An annual allowance for pension savings applies and limits the amount of tax privileges available on pension savings each year.

Members are subject to a 40% tax charge on the amount of any contribution (both member, contributions on behalf of the member and employer) paid in excess of the annual allowance each year. This also applies to any benefit increase under a defined benefit or cash balance scheme over the annual allowance.  If an annual allowance charge is due this will be dealt with through the member's tax return. (See Contributions & allowances). 

Tax relief and the annual allowance charge work independently, so it's quite possible for contributions to receive tax relief but for an annual allowance charge to apply because the contributions are in excess of the annual allowance. For example, in the tax year 2008/09 the annual allowance is £235,000.  If a member had relevant UK earnings of £300,000, they could receive tax relief on gross contributions of up to £300,000. However they would have to pay an annual allowance charge of 40% of (£300,000 - £235,000) = £26,000.

To avoid double taxation, it’s only contributions that receive tax relief that count towards the annual allowance.  The member is liable for the charge, even if all or part of the contributions have been paid by someone else such as an employer. So, if the member's earnings were £250,000 and they made contributions of £300,000, they would pay an annual allowance charge of 40% of (£250,000 - £235,000) = £6,000 but wouldn't get tax relief on the £50,000 gross contributions in excess of their earnings. 

What are relevant UK earnings?

The definition is:

• employment income,
• income which is chargeable under Schedule D and is immediately derived from the carrying on or exercise of a trade, profession or vocation (whether individually or as a partner acting personally in a partnership).  Schedule D is the schedule that self-employed earnings are taxed under, and
• income to which section 529 of Income and Corporation Taxes Act 1988 (ICTA) (patent income of an individual in respect of inventions) applies.

This therefore means that salary can count as relevant UK earnings but dividend income can’t – an issue important to, for example, controlling directors in deciding whether to pay a pension contribution as an employer or employee contribution.  See Employer contributions and tax relief.

Part of a redundancy payment can count as relevant UK earnings.  Any part of a lump sum payment made on redundancy that consists of items such as usual wages or salary, a payment in lieu of notice or holiday pay will be relevant UK earnings.

Not all of the actual redundancy payment is treated as employment income. Any part of the redundancy payment that’s below the £30,000 tax-exempt threshold is not classed as employment income and doesn’t count towards total earnings received in that tax year. However any amount above the £30,000 threshold is classed as employment income and is therefore also relevant UK earnings.

As an example, say a member receives a lump sum payment on redundancy made up as follows:

• one months salary                                £1,500
• one months salary in lieu of notice    £1,500
• holiday pay                                              £750 
• redundancy payment                            £31,250                  

The first three items would be relevant UK earnings.  In addition, £1,250 of the redundancy payment would also be relevant UK earnings. 

Who can make a payment?

A contribution can be made by:

• the member
• an employer, who may then be able to claim corporate tax relief on their contribution.  See Employer contributions and tax relief
• a third party. The third party can be an individual, a corporate body or other legal entity (but not the member’s employer, who can only make an employer’s contribution). The member will receive any tax relief due on the contribution, not the person who made the contribution. This would include any higher rate tax relief due if the member was a higher rate taxpayer.

How is tax relief on the member’s contributions given?

There are three methods by which a member can receive tax relief – the method to be used is determined by the method the pension scheme is allowed to operate by the legislation.

Relief at source (RAS)

Relief at source is used unless another method such as the net pay arrangement is available.  Personal pension plans will for example use relief at source.

The pension contribution is paid from the member's net earnings, i.e. after the payment of income tax and National Insurance contributions. When the contribution is received by the scheme administrator, basic rate tax relief is added to the contribution. The scheme administrator then reclaims the tax from HMRC.

A member who is a higher rate taxpayer can receive higher rate tax relief, usually by making a claim on their self-assessment return. 

Net pay arrangement 

Net pay arrangements can be used by occupational pension schemes for employee contributions so long as it’s used for all contributing members. Net pay can also be used by public service pension schemes and marine pilots' benefit funds. The employer deducts the relievable pension contributions from an employee’s salary before operating PAYE (but not before deducting National Insurance contributions).

In this way a higher rate taxpayer can get tax relief at their marginal rate immediately without the need to claim higher rate tax relief through their self-assessment form.

Relief on making a claim

Using this method, the member makes a gross contribution to the pension scheme and claims the tax relief from HMRC in a similar manner to claiming higher rate tax relief using the relief at source method.

Relief on making a claim is used where it’s not possible to use either of the previous methods. Examples would be where the provider of a retirement annuity contract doesn’t operate the relief at source system or where a third party contribution is being made in respect of a member of an occupational pension scheme that uses the net pay arrangement.

How is tax relief calculated?

For someone who is a basic rate taxpayer, this is straightforward.  Under the relief at source system, if someone pays £80 to their pension scheme, basic rate tax relief is claimed by the scheme administrator from HMRC and added to the net contribution to give a gross contribution of £100 (£100 less 20% basic rate tax equals £80).

Using the net pay arrangement, the employer would deduct  £100 from the employee’s salary and pay this into the pension scheme as a gross contribution.  As the employee’s salary is reduced by the £100, income tax will not be deducted from this amount.  This means that in effect, the £100 contribution has cost a basic rate taxpayer £80 and they are in the same position as under relief at source.

Using relief on making a claim, the member would make the payment of £100 and then claim £20 tax relief through self-assessment. 

If the above member is a higher rate taxpayer, does that mean that the £100 contribution will only cost them £60?   The short answer is …maybe.

Higher rate tax relief is given by extending the basic rate tax band by the amount of the gross pension contribution. Using the above figures, if the £100 isn’t greater than the earnings taxed at 40%, then the whole amount will be eligible for tax relief at 40% and the net cost to them will indeed be £60.  If the £100 is greater than the earnings taxed at 40%, only part of it will be eligible for tax relief at 40% and the net cost will be somewhere between £60 and £80.

An example might make this clearer.

Helen earns £45,000 p.a in 2008/09. Basic rate tax applies to taxable earnings up to £34,800 and higher rate tax on the amount above this. 

Her tax situation before making a pension contribution would therefore be:

Personal allowance                                               £6,035

Taxable income                                                       £38,965 (£45,000 - £6,035)

Basic rate tax:

= £34,800 at 20%                                                     £6,960

Higher rate tax:

= £4,165 (£38,965 - £34,800) at 40%                    £1,666.

Total tax                                                                       £8,626 

If Helen made a gross pension contribution of £5,000 under the relief at source system, the basic rate tax band would be increased from £34,800 to £39,800. Helen only has taxable earnings of £38,965 so she will only pay basic rate tax.

Tax:

£38,965 (£34,800 + £4,165) at 20%                        £7,793 

 £0 at 40%                                                                             £0              

Total tax                                                                          £7,793

The total amount of tax relief Helen has received is therefore basic rate tax relief of £1,000 (20% of £5,000) and £833 (£8,626 - £7,793) = £1,833.  This is 37% of the gross contribution, not 40%.

If Helen had made a gross contribution of £4,000, the calculation would have been:

Tax:

£38,800 (£34,800 + £4,000) at 20%                       £7,760

£165 (£38,965 - £38,800) at 40%                                £66

Total tax                                                                         £7,826

The total amount of tax relief Helen has received is therefore basic rate tax relief of £800 (20% of £4,000) and £800 (£8,626 - £7,826) = £1,600.  This is 40% of the gross contribution. This is because the contribution of £4,000 is less than £4,165 (the earnings that would have been taxed at 40% - see first calculation). 

If Helen’s £5,000 contribution had been paid under the net pay arrangement, the calculations would have been as follows:

 Income:                                             £45,000

Less pension contribution              £5,000       

Less personal allowance                £6,035        

Taxable income                                 £33,965      

Tax:

£33,965 at 20%                                 £6,793

This is £1,833 less than her tax liability if no contribution had been paid (£8,626) and is therefore 37% as under the relief at source system.  The difference is that Helen has had her total tax relief immediately instead of having to claim her higher rate tax relief through self-assessment.  If she had paid a contribution of £4,000 she would have received tax relief of 40% immediately through a similar calculation.

Any research and analysis has been provided by us for our own purposes and the results of it are being made available only incidentally.

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.

Published 29 August 2008