Pension contributions – tax relief and how to get it

Most people know that they can get tax relief for contributions they make into their pension funds, but surprising numbers do not really understand how relief works in practice and whether they are actually getting the relief they should. The route you take for pension relief affects National Insurance Contributions (NICs) and, with rates increasing from next April, can have an important role to play in minimising the additional costs.

We’re not talking here about the rules that limit what you can put into the fund each year – the annual allowance – but rather about the mechanics of getting relief. There are broadly three routes to putting money into your pension fund:

1.           Payments out of taxed income – relief at source arrangements

This scenario mainly applies to the self-employed, or at any rate, those whose earned income is not taxed under PAYE. The individual makes a contribution out of post-tax income and that contribution is treated as being made net of basic rate tax. The pension fund reclaims basic rate tax, so if the taxpayer contributes £80, the fund will reclaim £20 from HMRC. The £80 contribution and £20 tax reclaim make a gross contribution of £100. Higher or additional rate taxpayers can claim higher or additional rate tax relief on their contributions via their tax return. This is achieved by extending the basic rate and higher bands by the gross contribution so that the taxpayer gets the additional 20% or 25% relief by paying tax at 20% on what would have been higher or additional rate income.

2.           Net pay arrangements

Net pay arrangements are frequently used by employers for employees making contributions to occupational schemes. Usually both employees and employers will contribute, but the employee’s pension contributions are withheld at source in the payroll. This means that PAYE is applied on the net pay after deduction of the pension contribution. Pension contributions are not a taxable benefit so this arrangement provides full relief for income tax purposes. For the employer, corporation tax relief should be available for the full cost.

The downside is NICs. Although there is no employer’s NIC on the pension contribution, for the employee, NIC is still calculated on the gross pay.

3.           Salary sacrifice

This last route is generally the most tax efficient and is more likely to be used for senior employees who are perhaps able to negotiate a bespoke contract, or for owner-managed business proprietors who, similarly, can set their own employment terms.

In this case, the employee (who may well be a director of their own company) and employer come to an arrangement whereby the employee forgoes part of their salary in return for the employer making the whole (i.e. both employee and employer) contribution to their pension scheme. It is therefore as though the original salary never existed and, by not taking the salary there is no liability for employee or employer NIC on the employee’s pension contributions. Directors of their own companies may not need a formal sacrifice arrangement – it’s more a matter of building pensions into a tax-efficient remuneration structure. Nevertheless, the administration still needs to be managed carefully.

An employer company switching to salary sacrifice must meet legal requirements, not least the need to secure each employee’s consent. Corporation tax relief should be available for the full cost, provided that the contribution meets the normal requirements for tax deduction; in particular, the cost must be ‘wholly and exclusively’ laid out for the purposes of the business. This can make it difficult to justify, for example if there are significant contributions for a non-working spouse.

With the 1.25% increase in NICs from April 2022, salary sacrifice arrangements will become even more valuable. If you are self-employed you’ll be stuck with increased Class 4 NIC rates at 10.25% from the lower threshold up to £50,000 and 3.25% above that. If your self-employed income is £100,000, that will cost you an extra £1,130. For everyone else, the salary sacrifice route is the way to make a dent in both your tax and NIC bills.

Further reading:

Capital gains – getting the basics right to save tax

Important information:

Tax laws are subject to change and taxation will vary depending on individual circumstances.