How Do Pension Contributions Work?

If ever there was government legislation that seemed designed to be as complicated as possible, it would be pensions legislation.

The system is complex, and there are a heap of different rules that apply, depending on the type of scheme you have. A lot of these rules and details don’t even apply to modern pensions, which can make the whole thing even more confusing.

But don’t worry, we’ve got your back. In this article we’re going to explain exactly how pension contributions work, why so many financial advisors recommend them and how to work out what you’re able to pay into your scheme every year.

Before we get into it, we should mention that this article isn’t going to cover Defined Benefit or Final Salary Schemes. Those are specific types of workplace pension schemes that don’t generally allow you to pay your own money in, and they don’t have an investment pot behind them. They’re not that common these days, and mainly apply to public sector workers like those in the NHS.

Ok, let’s get into the details.

Why Are Pensions Worthwhile?

We’re going to discuss the how of pension contributions, but the first thing we really need to cover is the why. Why would you put money into a pension? Anything you contribute is locked away in the account until you’re at least 55 years old, so it would have to be pretty attractive as an investment.

And it is. The key benefit is that pension investments are able to grow completely free of tax. There is no capital gains tax and no income tax at all, while the funds remain inside the pension wrapper.

Given that pensions are usually used to plan for retirement, this means you can take advantage of potentially decades of compound growth that’s not impacted by tax.

Now, any withdrawals you make from a pension scheme once you reach retirement age can attract income tax, so you probably won’t avoid it altogether, but it’s still a very attractive way to build up assets for use later in life.

The tax benefits don’t end there though.

You also get what’s called ‘tax relief’ when you pay money into a pension, which effectively pays you back for the income tax you will have paid on the contribution. We’ll explain tax relief in more detail in the next section, but before we do, there’s one other tax benefit for investing through a pension for us to mention.

And that’s inheritance tax (IHT). If you’re UK domiciled in your later life, IHT will probably become a big concern. This tax charges your estate 40% tax when you pass away, for every £1 you have over £1 million (for a couple who own a property).

That means that if you had an estate valued at £1.5 million, your children would be on the hook for a tax bill of £200,000 (£500,000 x 40% = £200,000). Given the average price of a property these days, it’s not difficult to end up in the IHT zone.

However, pensions are exempt from IHT. That’s right, no matter how big your pension scheme is, it’s completely free from Inheritance Tax.

So the TL;DR? Pensions save you a lot of tax.

We’ve talked before how a pension compares to an ISA in more detail, which you can read here.

Tax Relief Explained

One of the biggest benefits of investing through a pension is the ability to receive tax relief on any money you put in. This is designed to reimburse you for the income tax you will have paid on money that’s going into your pension.

Basic Rate tax relief is paid into your pension directly, and if you’re a Higher or Additional Rate taxpayer you can claim extra tax back when you complete a self assessment tax return.

The easiest way to explain this is to show you an example:

Wei is a Higher Rate taxpayer as she earns £85,000. She decides that she’d like to start putting a bit of extra money away for her retirement, even though it’s still a long way off given she is 38.

She decides that she can afford to contribute £3,000 per year into her pension. She can make this as a monthly regular payment or on an ad hoc basis when she has some spare cash. From a tax perspective, there's no difference.

When Wei pays the £3,000 into her pension, she will receive Basic Rate Tax Relief of £750 directly into her pension, which is known as relief ‘at source’. This tax relief takes into account the fact that Wei has had to pay 20% Basic Rate Tax on her income before being able to save the £3,000. 

When Wei makes a payment into her pension scheme, the provider calculates this tax relief for her and automatically adds the tax relief into her account. 

However, as Wei is a Higher Rate taxpayer, she pays more than 20% tax on her income. Because of this, she can also claim back an additional £750 in her self assessment tax return, to reclaim the Higher Rate tax on her contribution. This doesn’t go back into the pension, but instead gets paid directly to Wei.

This means Wei receives 20% tax relief into her pension, and 20% back in her tax return, which equates to the 40% income tax she pays as a Higher Rate Tax payer. Note that Wei can only claim the extra Higher Rate Tax because she is a Higher Rate Tax payer. If she earned less £50,270 then she’d be a Basic Rate Taxpayer and would only receive the 20% tax relief at source.

In total, this means that if Wei makes a contribution of £3,000 she will get an additional £1,500 back through a combination of extra payment into her pension and directly into her pocket. 

That’s a huge benefit to investing through a pension.

Next, we’ll show you the calculations for these figures, as it might make it easier to understand the calculation. If formulas make your eyes glaze over, you can skip the next bit.

TL;DR - When you pay into a pension, you get tax relief cash back as a ‘refund’ of the income tax you paid on that money. 

Basic Rate tax relief goes directly into your pension scheme automatically, and if you’re a Higher or Additional Rate taxpayer you (or your accountant) can claim back the extra in your self assessment tax return.

Tax Relief Calculations Explained

The terminology that’s used for the tax relief calculation is called ‘grossing up’. The idea behind this is that the money in your bank account is net of tax, and therefore to work out your tax relief we need to calculate the gross income you received for that money.

The calculation for Basic Rate tax relief for Wei is £3,000/80% = £3,750. So the grossed up figure is £3,750, meaning the tax relief is £750.

The reason we use 80% is because Basic Rate Tax is 20%, and we’re looking for the before tax figure to work out the tax relief. When she claims back her Higher Rate tax relief, she’ll receive an additional £750 to bring the total tax relief to 40%.

Understanding Annual Pension Allowances

Ok, so by now hopefully you understand that pensions are a very tax effective way to invest. There are some limitations though. First off, you can’t access the money for potentially a very long time. At the moment, you can’t withdraw from a pension until you turn 55.

The other issue to be aware of is that there is an annual limit on how much you can contribute into a pension scheme.

Pension Annual Allowance

The maximum you can contribute into a pension in a single year is the lower of your earned income, or £40,000. So if you earn £35,000 from a salary then that is the maximum you can contribute into a pension scheme. If you earn £80,000 then £40,000 is the max amount that can be paid in.

The word ‘earned’ income is key here. You can’t use income from investments or property against your pension annual allowance. It has to be from employment or self-employment.

Everything that goes into your account is included in this figure. So it includes the basic rate tax relief as explained above, plus any employer contributions that go into your account.

If you have a direct debit going into a pension fund each month, it’s important you check the tax relief amount that’s being added, because it can be easy to forget about this and just think about the amount that’s coming out of your bank account.

Keep in mind that because the allowance is based on what goes into your pension account, Higher or Additional Rate tax relief isn’t included because it’s paid to you directly, not into your pension scheme.

Tapered Annual Allowance

Once you have adjusted income of over £240,000 your pension annual allowance starts to decrease. Adjusted income is your income before any deductions, including your personal allowance, any trading losses, charitable donations and pension contributions.

Your annual allowance reduces by £1 for every £2 over this figure, and tapers down the more income you earn down to a minimum of £4,000 per year.

The calculations for this get pretty complicated, and honestly if you’re earning this much it’s worth paying for some professional advice to make sure you’re doing everything correctly.

Carry Forward Rule

But wait, there’s one more wrinkle in the pension rules. As long as you’ve been a member of a pension scheme in the past three financial years, you can bring forward any unused allowance into the current tax year.

Say you’ve been paying in £20,000 into your scheme for the past three years, that means you would be able to carry forward £60,000 of unused allowance (3 x £20,000) to use this year. That’s in addition to the £40,000 allowance you already have for the current year, meaning you could contribute up to £100,000 in the current tax year.

You still need to have earned income at that level, so in this case you’d need to have an income of at least £100,000 to be able to make the contribution.

This can be a particularly useful strategy if you come into a lump sum of cash, as you get a huge amount of tax relief on a contribution of this size.

Workplace Pensions

The last area of pensions to discuss are workplace pensions. It’s now a legal requirement for employers to enrol their employees into a workplace pension, which is known as auto-enrolment.

The minimum requirements are for the employer to contribute 3% of the employees salary, and for the employee to contribute 5% themselves. Not every employee qualifies for auto enrolment, but if you earn over £10,000 then you have to be enrolled. 

As an employee, you can also opt out of the pension once you’ve been enrolled. This means you won’t have to pay the 5% yourself, but it also means you lose out on the 3% from your employer as well. 

Your Pension Next Steps

To get your pension house in order, there are a few important steps you need to take.

• Gather all the details of existing pensions. It’s common to accumulate a few different pension schemes when you move jobs. If you need help tracking them down, we can help.

• Review the way your pensions are invested to make sure it aligns with your goals and the way you feel about risk and volatility.

• Consider how your pensions combine with your other investments to get an overall projection of net wealth. This can be done easily on the Rosecut app.

• If you want to improve the projection and start planning for a bigger pension and a better retirement, get in touch.

If you want to learn more about pensions and planning through your life, we’ve got a number of other articles for you to dive into.

Please note that this is not a financial advice and it does not take into account individual circumstances. Please also contact a professional advisor prior to any decision making.

The value of an investment and the income from it can go down as well as up and investors may not get back the amount invested. This may be partly the result of exchange rate fluctuations in investments which have an exposure to foreign currencies. You should be aware that past performance is no guarantee of future performance.