The government has been pushing workplace pensions for some time, and pension savings attract valuable tax benefits. Not only are the contributions free of tax at the point of payment, but the contributions can reduce your taxable income for the purposes of other reliefs. However, relief at higher tax rates has been a target for restriction for many tax years.
The amount that can be paid into pension schemes tax-free is capped, but the level of the cap will depend on individual circumstances.
It is highly recommended to seek professional advice when exploring the possibility of making lump sum payments into pensions, as exceeding the annual allowance limit can result in costly charges. To learn more about your pension contribution limits and annual allowance charge, look at our blog below.
Is there a cap on the pension contributions you can make?
Although there is no definitive restriction on how much can be paid in pension contributions, there are limits to the amount that may qualify for tax relief.
Since April 2014, the cap on annual pension contributions that qualify for tax relief has been limited to £40,000. This limit was further restricted for higher earners from April 2016. However, in the March 2023 Budget, this limit was increased to a maximum of £60,000.
In addition, the total contribution cannot exceed your earned income in the tax year. However, if you earn less than £3,600 in the tax year, you can pay up to £3,600 in gross contributions.
The concept of a lifetime allowance was introduced in 2006 and capped the tax-free capital value of a pension fund at £1,073,100. This limit is removed from 5 April 2023.
What is the difference between a defined benefit and a defined contribution pension?
There are two types of pension schemes:
- Defined benefit schemes
- Defined contribution pension schemes
Defined benefit pension schemes, commonly referred to as final salary schemes, determine the amount of pension you will receive in advance. A complex calculation is used to compare this amount with the annual pension allowance and lifetime limit. Such schemes are still relatively common in the public sector, whereas the private sector has shifted mainly towards defined contribution pension schemes.
In a defined contribution pension scheme, the pension eventually received depends on the amount paid into the scheme. The above limits are applied to the contributions paid into the scheme and the total value of the fund at the time of drawing pension benefits or a lump sum.
What is the annual allowance tax relief on pension contributions?
Each tax year, the maximum pension contributions on which tax relief will be given is £40,000 (increasing to £60,000 from 6 April 2023). This includes personal contributions and employer pension contributions.
Since 2016, if your total income for the year exceeded a threshold, your annual maximum is further restricted by £1 for every £2 that your income exceeds the threshold until your allowance is reduced to £4,000 (£10,000 prior to April 2020 and from 6 April 2023).
The good news is that if you don’t make the maximum annual pension contribution, there is a mechanism to carry forward unused annual allowance for up to the previous three tax years.
What happens when you exceed the annual allowance?
Whether you exceed the pension contribution limits because of your own contributions paid or your employer pension contributions, you will have an annual allowance charge on the excess contributions at your highest rate of income tax. This is usually reported to HMRC through your Self Assessment Return for that tax year.
The tax charge can be significant, and to assist with funding the tax liability, the pension provider will usually consider settling the tax charge on behalf of the individual.
Each scheme will have its own rules about settling the tax charge but bear in mind that the payment reduces your fund and will impact your pension entitlement in due course. It is advisable to speak to your IFA about investment decisions like this.
Get help with your pension planning with Butt Miller
We can work in tandem with your financial adviser to help you through the minefield of pension and tax rules to make sure your pension savings fit your personal circumstances and make the most of the allowances available to you. Contact us today.
FAQs about pension contributions
If you’ve got more questions about pension contributions, please contact us or check out our FAQs:
How many pension schemes can you be invested in?
There is no limit to the number of pensions you can invest in as long as the total amount paid in the tax year is less than the annual cap. Bear in mind, however, that splitting your pension pot may mean that the money could be performing better in a single fund, and your investment value could be higher if you combine your pots.
When you come to retire, having multiple pension funds can complicate your options when taking a pension or a lump sum.
Can I contribute 100% of my salary to my pension?
The ability to put all of your salary into a pension scheme has been limited by the pension cap introduced in 2016. If your salary is more than £40,000 and you don’t have any relief brought forward from the three previous tax years, the maximum pension contribution will be £40,000, increasing to £60,000 from 6 April 2023.
What is a money purchase annual allowance?
Once you start to receive your pension, the limit on the amount you can continue to pay into your pension scheme is reduced to £4,000 per year, increasing to £10,000 from 6 April 2023. This is designed to stop you from “recycling” pension income to use the tax reliefs multiple times.
How will I receive tax relief?
Tax relief is determined by whether pension contributions are taken from your gross pay before tax is calculated or if the contributions are paid out of post-tax income.
Contributions paid out of your income before tax are applied to reduce your taxable income and will not give you any further tax relief.
If contributions are paid out of your net income, you will only pay 80% of the contribution due, and the pension scheme will claim back the remaining 20% from HMRC. If you pay tax at higher rates, you will be due further tax relief on contributions taken from your net pay.
You will need to contact HMRC to receive tax relief at higher rates on the amount you pay into your pension, which can either be given as an adjustment to your PAYE code or through a Self Assessment Tax return.
I’ve been told salary exchange will save me money on my pension contribution. How does that work?
Salary exchange or salary sacrifice means giving up part of your gross income in return for employer pension contributions. The tax position is the same as paying personal contributions, but you will save National Insurance on the salary exchanged.
Your employer also benefits from not having to pay National Insurance on the contributions you pay into your pensions.
How much tax relief will I get on my pension contribution?
Employer contributions are not taxed, so there will be no further tax relief due to you. Personal pension contributions will attract 20% tax relief when you make the payment, and you can then claim the difference between the 20% already given and your actual tax rate.
If you pay tax at 40% on your income, you can claim back an extra 20% of tax relief from HMRC and an extra 25% if you are in the highest tax bracket.
My employer’s contributions exceed my annual allowance. Should I ask them to stop payments?
If your employer is prepared to pay you the excess pension contributions as salary, you will be better off overall.
To learn about how pension tax relief works, read our blog.