Pensions tax relief – How it works

For decades now, pension tax relief has been the cornerstone of policy for successive governments to promote saving for retirement and to reduce dependence on the state pension. Alongside specific initiatives, such as employer auto-enrolment obligations, most workers will now have some kind of pension nest egg.

Here, we explore all the key aspects of pensions tax relief and how it may affect you.

Read more about pensions for retirement and succession planning. 

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The basic rules

Contributing to a pension has always been a tax-efficient method to save towards retirement. If you are UK resident and under 75, you will be eligible for tax relief on contributions into your pension.

The maximum amount of tax relief you can receive depends on

a) Your UK earnings; and
b) Your available annual allowances

 
Contributions to personal pension schemes are normally paid net of basic rate, with the pension fund claiming an amount equivalent to that basic rate from HMRC. Higher or additional rate relief is then claimed on the self-assessment tax return. Personal pensions are primarily used by the self-employed, including partners, but where the member is an employee (perhaps as a member of a group personal pension scheme), higher and additional rate relief may also be available through the PAYE tax code. In practice, this extra tax relief is given by extending the basic rate band and higher rate band by the gross amount of the pension contribution.

In contrast, employees making contributions into their employer’s defined benefit scheme or net pay scheme will receive full relief at source through their employer’s payroll. Essentially, taxable salary will be reduced by the employee’s contribution before calculating the tax, known as a ‘net pay scheme’. SMART, or salary sacrifice, schemes work on a similar basis, excepting that technically the employee has given up an element of their income in return for greater employer contributions, so strictly the income itself has reduced by the amount sacrificed rather than a relief being applied by the employer.

Tax relief also extends to the growth in the value of pension savings, as the pension fund itself will not pay tax on its investment returns.

Having effectively paid monies into the pension scheme and grown the fund tax free, it is then usually possible to extract 25% of the ‘pension pot’ (up to the lump sum and death allowance, see below) as a tax-free lump sum when you commence drawing down retirement benefits, currently from the age of 55 (although this will increase to 57 from 2028).

The remaining 75% of your pension pot will usually be taxed through PAYE at your marginal rates of income tax as and when you receive it, so the rate will depend on your level of all other taxable income in that tax year.

Employers are now required by law to offer a workplace pension scheme and to automatically enrol eligible employees into it. Under auto-enrolment, the employer must also make a minimum level of contributions on behalf of each employee. Currently, an employer and employee must pay a minimum of 3% and 5% respectively under the automatic enrolment scheme, based on the employee’s qualifying earnings. All occupational schemes (as described below) are designed to meet the employer’s obligations, but the Government also created the national employment savings trust (NEST) as an option for smaller employers. NEST has a contribution limit of £3,600 pa, so is not attractive to high earners.

Pension schemes can be categorised between defined benefit and defined contribution schemes as well as between personal and occupational schemes.

Defined benefit schemes (also known as final salary or earnings-based schemes) are broadly occupational schemes where contributions are made to a general fund from which an employer promises to pay an amount of pension to an employee on their retirement. The amount of pension the employee receives is based upon how long they have worked for their employer and their level of earnings during their years of ‘pensionable service’. These schemes are becoming increasingly rare, and many are closed to new joiners. Any investment risk rests solely with the employer as they must ensure that there are sufficient funds available in the pension fund to eventually pay the promised benefits.

All personal and most current occupational schemes are now defined contribution schemes (also known as money purchase arrangements). Contributions are made by the member, and for occupational schemes by the employer and member combined to build a pension fund with the member having control on how to use it at their retirement. Any investment risks rest solely with the member whose eventual benefits will depend on the growth of the fund.

Most occupational schemes are either net pay schemes or SMART pensions. Under net pay schemes, employees receive their tax relief for contributions through their employer’s payroll by a reduction to their taxable pay. SMART, or ‘salary sacrifice’ schemes work by the employee giving up an element of their salary in lieu of a greater employer contribution. Tax relief for SMART schemes operates through the fact that contractually the employee is receiving less salary to be taxed. The employee’s income tax position remains the same under net pay and SMART schemes, but importantly, under salary sacrifice the employee is also receiving less remuneration for NIC purposes, and there is therefore an NIC saving for both the employee and employer. However, the Chancellor announced in her 2025 Budget that NIC relief will be capped for salary sacrificed contributions at £2,000 per year, with contributions exceeding £2,000 being subject to employee and employer NIC from 5 April 2029. Read more on SMART Pensions here.

Personal pensions are schemes set up by an individual, often self-employed, for themselves. They are in practice a money purchase scheme and the investment risk rests with the individual member as with any defined contribution scheme. Contributions are paid net of basic rate tax, with higher rate relief claimed through completion of tax returns.

Group personal pensions are occupational schemes that operate for the member on a similar basis as personal pensions. The employer acts as agent through its payroll by withholding contributions out of net pay. Higher rate relief for contributions are claimed either through a tax code adjustment or by completion of a tax return. The employer will often make additional contributions to the scheme, paid gross of tax.

Self-invested personal pensions (SIPPs) and small self-administered schemes (SASSs) – SIPPs and SSASs are types of defined contribution pension schemes that allow the member greater control over the investment of the funds. SIPPs are personal schemes, whereas SASSs are occupational schemes mostly used for executives.

Additional voluntary contributions (AVCs) might be made by employees into a defined contribution scheme. An employer might set up such a scheme to run alongside a defined benefit scheme to enable staff to make additional pension savings. With the closing of many defined benefit schemes, AVCs are becoming less common.

Given that contributions are made throughout a person’s working life, you may be a member of a legacy scheme. You may no longer be able to contribute to such schemes, but they retain the same tax status as other registered pensions as they grow and when you access them. Perhaps the most common of these are retirement annuity policy schemes (RAPS). If you took out a personal pension before 1 July 1988, it will most likely have been a retirement annuity policy. Quite often these included insurance policies with any payments also treated as being pension payments.

Broadly you are entitled to pension tax relief if:

  • You are tax resident in the UK
  • You have relevant UK earnings
  • You were UK tax resident at sometime during the previous five years, or
  • You, or your spouse, are an overseas Crown employee.

The maximum amount of member contributions on which you are able to receive tax relief is the higher of:

  • £3,600 gross (£2,880 net), and
  • The amount of your relevant UK earnings.

This restriction does not apply to employer contributions which, by their nature, are effectively earnings. In practice, it should not apply for employee contributions either, given that they are a deduction from, and calculated as a percentage of, earnings.

If you have made contributions in excess of your entitlement, then you should speak to your pension administrator. For personal pensions, they will need to return basic rate tax to HMRC, and you can request a repayment of your excess contributions.

The annual allowance (AA) rules do not themselves affect the mechanism for you receiving tax relief on your pension’s contributions, but they impose a tax charge to effectively claw back tax relief given where your ‘pension input’ exceeds a particular threshold.

If your level of ‘threshold income’ (broadly, net income excluding pension contributions) is below £200,000 in a tax year, you and your employer can make gross contributions to your pension funds of up to £60,000 without a charge arising.

If your ‘adjusted income’ (broadly, net income including personal and employer pension input) exceeds £260,000, and your threshold income exceeds £200,000, your AA will be tapered at a rate of £1 for every £2 of adjusted income above £260,000. The maximum reduction to the AA is by £50,000, so anyone with adjusted income of £360,000 or more has their AA tapered to the £10,000 annual minimum.

For defined contribution schemes your AA is calculated with reference to actual contributions by you and your employer during the year. For defined benefit schemes they are based on your ‘pension input’, being the increase to your pension rights over the course of the year, reflecting an additional year of service and changes to your salary.

For both types of schemes, to the extent that you have exceeded your available AA, you can reduce the chargeable amount by any unused AAs from the previous three years, using the oldest first.

If you and your employer’s pension input still exceed your available AA after brought forward surplus, then an AA charge will apply. This is calculated by applying your marginal rate of income tax to the excess.

When a person first accesses a pension of any kind to draw income, their available AA for all subsequent years, for the purpose of defined contribution schemes, is automatically tapered to the MPAA, regardless of their income level. The MPAA is £10,000. Therefore, individuals who have already started to take pension income but have resumed or continued work, can only make modest top ups to their pension funds (compared to the maximum annual allowance of £60,000).  

However, we note that if structured correctly, it is possible to access your 25% tax-free lump sum without triggering the MPAA.   

Furthermore, although the MPAA can be triggered by benefit withdrawals from defined benefit schemes, the MPAA does not apply to pension input into such schemes, which remains within the standard AA regime described above. 

From 6 April 2024, the lifetime allowance (LTA) was effectively renamed the lump sum and death benefit allowance (LSDBA) and retained with the sole purpose of restricting the available PCLS. The lump sum allowance (‘LSA’) is a person’s maximum tax-free lump sum available to them across all their pensions; generally being £268,275, i.e., 25% of the LSDBA.  

Under transitional rules, the LSDBA is your unused LTA as at 5 April 2024, therefore, for most people, the LSDBA is £1,073,100. However, it will:

  • Increase where an individual has previously obtained one of the historically available LTA ‘protections,’ 
  • Decrease where an individual had a benefit crystalising event before 6 April 2024 under the LTA regime (e.g., they started drawing benefits, or had a 75th birthday), which would have used up some of their LTA
  • Decrease where they have taken a PCLS on or after 6 April 2024. 

In the 2024 Autumn Budget, the Government announced the effective abolition of the IHT exemption for pensions from 6 April 2027. The aim is to prevent pensions from being used as a tool for avoiding IHT. Read more about pensions for retirement and succession planning.

Overseas pension schemes

You may have accrued benefits in an overseas pension scheme whilst working for an overseas employer. If you are UK-resident, there are income tax implications to consider if you wish to access benefits from your overseas scheme in the form of an annuity or lump sum payment. Overseas pension schemes are a complicated area of pension taxation and legislation. 

Generally, UK income tax is payable on overseas pension income (including equivalent state pensions) of a UK tax resident individual, subject to double tax treaty provisions and possibly from 6 April 2025, foreign income and gain regime (for new arrivals to the UK) – read more.  

Lump sums from overseas pension are a particularly complex matter for which specialist advice is required. Lump sums can theoretically fall to be taxed under a number of different provisions depending on the facts. If you are able to satisfy yourself that the other provisions do not apply, then the general provisions introduced with effect from April 2017 will most likely be relevant. 

Under these provisions, if there is sufficient relevant foreign service, a pension pot deriving from such foreign service may only be taxable to the extent that it has accrued or increased in value since 6 April 2017. Even this subsequent growth might be fully exempt or subject to the standard UK ‘25% tax free’ provisions depending on the specific circumstances. 


Accessing UK pensions from abroad

There are a range of options available to access a UK pension from abroad all of which require advice from both an investment and tax perspective. Complexities arise from the how the applicable tax treaty operates and the treaty interpretation depends on how the pension is accessed. However, always more important than the tax, is the need for the pension holder to think about the pension in the overall context of their financial needs to ensure they have protected themselves from whatever the future brings. 

If you are looking for help or advice on pensions tax relief or any other pension tax issue please contact Chris Holmes or Elsa Littlewood.

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