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Contracting-Out Of The State Second Pension

The State Second Pension (S2P) is the earnings related state pension that replaced the State Earnings Related Pension Scheme (SERPS) from 6 April 2002. Our analysis The State Second Pension Explained gives full details.  Individuals can contract-out of S2P and this analysis explains what this means for final-salary, money-purchase and appropriate personal pension/stakeholder plans. It includes an example of how to calculate rebates for personal pension/stakeholder plans.

Final-salary scheme

Employees who are contracted-out through their employer’s final-salary pension scheme receive a national insurance contributions (NICs) rebate of 1.6%, that is they pay 1.6% less in NICs than someone who chooses to remain in S2P i.e. contracted-in. The employer receives a rebate of 3.7%. These rebates apply to earnings between the employee’s and employer’s NI thresholds and the upper accrual point (UAP).

Recognising that S2P has different accrual rates applying to different bands of earnings and that the final-salary rebates didn’t take this into account as they were a flat rate, a top up pension was introduced. This top up pension is based on the difference between what each individual would have received under S2P compared to SERPS assuming that they had not contracted-out. It applies to earnings up to the Secondary Earnings Threshold (SET), currently £31,800.

Money-purchase scheme

The rebate for those who are contracted-out by way of their employer’s occupational money-purchase scheme is made up of two parts.

  • A flat rate rebate of 3% of NICs, 1.6% for the employee and 1.4% for the employer.
  • An age-related rebate is paid after the end of the tax year by HM Revenue & Customs' National Insurance Contributions Office (NICO) directly to the pension scheme.

A link to the age related rebates available for money-purchase schemes can be found below:

Contracted-Out Money Purchase

The top up mentioned above for final-salary schemes also applies to money-purchase schemes.

Appropriate personal pension/stakeholder plan

For those who are contracted-out via a personal pension/stakeholder plan, no flat rate NICs rebate is payable. Employers are also not entitled to any rebate. Basically, an age related rebate is paid after the end of the tax year by NICO directly to the pension plan. This is based on the actual earnings within each band and the age related rebate percentage that applies. So, how do you work out what the rebate is?  The table that follows explains.  

Step 1 - Determine the age related rebate percentage

You’ll need to have a copy of the rebates that apply at the different ages. A link to these rebates is attached below:

Personal Pension/Stakeholder 

Step 2 - Calculate the earnings that apply in each band (all figures are for 2009/10 tax year)

Band 1 - earnings between the LEL (£  4,940) and the LET (£13,900)
Band 2 - earnings between the LET (£13,900) and the SET (£31,800)
Band 3 - earnings between the SET (£31,800) and the UAP (£40,040)

Step 3 - Calculate the total rebate payable

Multiply the earnings in each band by the rebate percentage to calculate the total rebate payable.

 

Here’s an example to show how the rebate payable is calculated.

 

Michael, a mechanic, is age 35 and has earnings of £34,000. He is contracted-out under a personal pension plan for the 2009/10 tax year.

Determine the age related rebate percentage

The age related percentage in each band is 12.6%, 3.15% and 6.3% respectively.

Calculate the earnings that apply in each band

Band 1 - £13,900 - £ 4,940 = £ 8,960
Band 2 - £31,800 - £13,900 = £17,900
Band 3 - £34,000 - £31,800 = £ 2,200

Calculate the total rebate payable

Band 1 - £  8,960 x 12.6% = £1,128.96
Band 2 - £17,900 x 3.15% = £   563.85
Band 3 - £  2,200 x 6.3%  = £   138.60            

Total rebate payable for 2009/10 tax year is £1,831.41.

 

It is worth noting that tax relief is granted in the personal pension/stakeholder plan in respect of the member’s portion of the rebate. This is 1.6%. In our example, the tax relief on the rebate is calculated as shown below.

Band 1 - £1,128.96 x 1.6/12.6 x 20/80 = £35.84
Band 2 - £   563.85 x 1.6/3.15 x 20/80 = £71.60
Band 3 - £   138.60 x 1.6/6.3  x 20/80 = £8.80 

Total tax relief on rebate is £116.24.

Total rebate invested in personal pension/stakeholder plan is £1,965.70 (£1,831.41 + £116.24) = £1,947.65.


As mentioned, the amount of rebate is based on actual earnings within each band. If you earn less than the Low Earnings Threshold (LET), currently £13,900, you would receive a S2P benefit calculated on earnings equal to the LET if you were contracted-in. So, if you contract-out and you earn less than the LET a S2P top up benefit is granted based on the difference between actual earnings and the LET. An example of how this is calculated, assuming earnings are revalued at approximately 2.5% per annum, is shown below.

David, age 20, joined his employer's GPP and contracted-out of S2P in the 2009/10 tax year. He has earnings of £12,000 and a working life of 49 years.

Band 1 (S2P)    - £13,900 - £4,940 = £8,960
Actual earnings - £12,000 - £4,940 = £7,060

Assume that the revalued earnings are £27,220 and £21,448 respectively.

Band 1 (S2P)    - £27,220 x 40%/49 = £222.20

Actual earnings - £21,448 x 40%/49 = £175.09

Total S2P top up benefit is £47.11 (£222.20 - £175.09).

Note - The S2P top up benefit would be converted into a weekly amount.

 

The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice.

The details shown are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.

 

Updated 3 April 2009

Published 27 April 2004

For professional advisers only