Are you getting the right tax relief on your pension?
Research from Prudential has suggested that approximately £229m a year is being unnecessarily kept by the tax man because more than 182,500 people have not claimed the correct tax relief on pension contributions.
Their findings reveal that 26% of UK employees who pay higher rate tax (on income over £41,450) did not claim higher rate relief on pension contributions.
Given that tax relief is one of the main reasons why you would invest in a pension it is staggering that so many people may be missing out.
Pension rules are complicated, and keep getting changed, so it is no surprise that people get confused. In order to make sure you’re getting the right tax relief, the first step is to make sure you know what type of pension you have. This in itself is complicated in that the pensions industry is full of jargon but there are two main types of pensions – defined benefit schemes and defined contribution schemes.
1 – Defined benefit
Defined benefit schemes are generally final salary schemes or “career average” schemes, where you are building a promise of an income at retirement.
2 – Defined contribution
(also referred to as “money purchase”)
Defined contribution schemes are where you build up an investment fund which can then be converted into an income at retirement.
If you have a Defined Contribution Pension, such as a SIPP, Stakeholder Pension or Personal Pension Plan, read on as you might be missing out on valuable tax relief.
Defined Contribution Pension
With a Defined Contribution pension any money you pay in is tied up until at least age 55. There are also certain restrictions as to how money can be drawn out of the fund at retirement as pension income is taxable.
In exchange for these restrictions, there are some benefits. Firstly, under current rules you can draw a quarter of your fund as a tax free lump sum after age 55. Secondly, growth within the pension fund is tax-efficient, in a similar way to ISAs. Thirdly, and perhaps most importantly, you receive tax relief at your highest marginal rate when you pay money in.
As an example, someone earning £30,000 who pays in £5,000 will receive 20% tax relief which means that the cost to them has only been £4,000. However, someone who earns £50,000 would only pay £3,000 to get £5,000 into their pension. This is because they receive 40% tax relief. Half of this is given “at source” – they write a cheque for £4,000 and £5,000 appears in their pension fund because the pension company deals with the tax reclaim. The other half needs to be reclaimed via HMRC and this is where people are going wrong.
Occupational Pension/Personal Pension
Where I feel most people get confused is where pension contributions are made on a monthly basis via an employer’s payroll and “just happen”. On pension schemes that fall under the “occupational” pension rules, all of the tax relief is dealt with via payroll so there is no need for employees to make a further reclaim. However, under the “personal” pension rules, only 20% relief is granted at source with the balance being reclaimed via Self-Assessment. Many employers operate schemes, like Stakeholder Pensions and Personal Pensions, that fall under the “Personal” rules. It’s no wonder so many people get confused and miss out on valuable tax relief.
40% tax relief is only the tip of the iceberg. Someone earning between £100,000 and £118,880 can obtain an effective tax relief rate of 60% due to the fact that once income exceeds £100,000 you start losing the tax free Personal Allowance on top of your 40% tax.
Someone earning over £150,000 can obtain 45% tax relief because that is their highest tax rate.
Pensions and Child Benefit
Also, where a household is in receipt of Child Benefit, this is now lost on a sliding scale once income exceeds £50,000 and is fully lost once it exceeds £60,000. However, a pension contribution can bring “adjusted net income” down to £50,000 so that Child Benefit is retained. Someone with three children earning £60,000 would stand to lose £2,450 of Child Benefit, on top of 40% tax, so the choice would be “do I want £10,000 in my pension or £3,550 in my pocket?”
If you think you might be missing out, or are unsure of how tax relief on your pension works, the first port of call would be the HR department at your work. If you’re employed in a smaller firm or need more detailed advice on how to make the most of the generous tax relief system speak to a Financial Planner.