Understanding pension tax relief

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If you don’t quite get pension tax relief, you’re not alone, but it pays to make the most of it.

The government encourages pension saving by giving tax incentives, making tax relief one of the major benefits of saving into a pension.

How does it work?

If you’re a basic rate taxpayer you can essentially contribute £100 into your pension for just £80. This means when you pay into your pension from your pay packet or make a single contribution, you’ll get a boost from the government in the form of tax relief.

And the more you pay into your pension, the more help you’ll get.

For example, if you pay basic rate tax:

You pay Tax relief added as a boost to your contribution Total contribution added to your pension plan
£80 £20 £100
£160 £40 £200
£240 £60 £300

If you pay a higher or additional rate of income tax you could benefit from additional tax relief which you can claim from HM Revenue & Customs (HMRC). Tax relief can change and depends on your individual circumstances and where you live in the UK.

Know your limits

Governments have tried to limit these benefits and there’s both an annual limit on how much you can contribute to a pension and qualify for tax relief, and a lifetime limit on the total pot that can be built up with the benefit of tax relief. If you go over these limits, you’ll have to pay a tax charge. The annual allowance is £40,000 per year and the lifetime allowance is £1,073,100 for the 2022/23 tax year. There are other limits to be aware of too such as the money purchase annual allowance and the tapered annual allowance. You can find out more about them in our Tax relief - know your limits article.

These may sound like big numbers, but it would be wrong to say these limits only concern the wealthy. The reality is that more and more people are being captured by these limits – for instance, people who may have had long service in a final salary scheme could find themselves breaching them.

Don’t miss out

If you’re getting close to either of these limits, it’s tempting to stop paying into your pension in an attempt to avoid a tax charge. However, this might not always be the best thing to do, as you could potentially miss out on many benefits by stopping contributions. For instance, you may miss out on large employer contributions that could really boost your income in retirement.

In addition, people in danger of breaching their annual allowance may worry about having enough money to pay the tax charge. However, there are instances where the scheme will pay the charge for you.

We've written a guide, Why saving beyond pension tax relief limits might not be a bad idea, which highlights some of the key things to think about when making this decision.

Seeking advice

It’s important to note that paying an annual or lifetime allowance charge is not an inherently bad thing. It isn’t a punishment for bad behaviour and it certainly isn’t a sign that you’ve done something unlawful. It’s merely a way for HMRC to claw back overpaid tax relief. As a result, avoiding the charge shouldn’t necessarily be your default position and you should think carefully about whether stopping contributions to avoid the charge or staying in the scheme and paying the charge will leave you better off in the long term.

These are complex issues that can have long-term effects on your financial wellbeing, so it’s a good idea to speak to an independent financial adviser before making a decision. They’ll go through your individual situation and advise you of the best way to proceed. Advisers may charge for their services – but they should agree any fees with you up front.