Pension Contributions and Tax Relief

Paying into a pension is one of the most tax-efficient things you can do with your salary. The government effectively tops up your contributions with tax relief, meaning the cost to you is less than the amount going into your pot. Here is how it all works.

The Basic Principle of Tax Relief

For every £80 a basic-rate taxpayer pays into a pension, the government adds £20 tax relief, making it £100 in your pot. For a higher-rate taxpayer, the real cost of a £100 pension contribution is only £60 — the government contributes £40. For additional-rate taxpayers it is only £55.

Salary Sacrifice

Salary sacrifice (also called salary exchange) is the most efficient way to contribute to a pension through work. Instead of paying you the money and you then paying it into a pension, your employer reduces your gross salary by the contribution amount before calculating tax or NI:

• You save income tax (20%, 40% or 45%) on the amount sacrificed
• You also save employee National Insurance (8% or 2%)
• Your employer saves employer NI (13.8%) — many employers pass some or all of this saving back to you as a higher contribution

Example: £35,000 salary, 5% salary sacrifice pension (£1,750/yr or £145.83/month). Your gross pay for PAYE purposes becomes £33,250. You pay income tax and NI only on £33,250, saving around £349 per year in combined tax and NI compared to paying via net pay.

Note: Salary sacrifice reduces your "official" salary for certain purposes — mortgage applications, life cover based on salary, and statutory pay calculations may all use the sacrificed salary. Check with your employer how benefits in kind are affected.

Relief at Source

Many personal pensions and some workplace schemes use relief at source (RAS). Your employer deducts contributions from your net (after-tax) pay, then the pension provider claims 20% basic-rate tax relief from HMRC automatically and adds it to your pot.

If you are a higher-rate or additional-rate taxpayer, you can claim the additional relief through your Self Assessment tax return or by writing to HMRC:

• Basic rate (20%) — claimed automatically by provider
• Higher rate (40%) — you claim an extra 20% via Self Assessment (total relief = 40%)
• Additional rate (45%) — you claim an extra 25% via Self Assessment (total relief = 45%)

Net Pay Arrangement

Some workplace schemes use a net pay arrangement. Your contribution is deducted from gross pay before income tax, so you automatically receive tax relief at your marginal rate. However, unlike RAS, basic-rate taxpayers do not get any relief if they earn below the personal allowance.

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