Pension tax relief is a great way to supercharge your finances, potentially adding thousands of pounds to your retirement savings.
It’s essentially free money and works by boosting your pension contributions with a top-up from HM Revenue and Customs (HMRC).
Pension savers who pay basic rate tax get a 20 per cent boost to their pension contributions, while higher rate taxpayers get a 40 per cent boost from the government.
Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, explains, “Pension tax relief is a powerful incentive to save for your retirement. Put simply, it means that tax you would have paid on your income goes into your pension instead.”
She adds, “You get tax relief at your marginal rate - so if you are a basic rate taxpayer a £100 pension contribution only costs you £80. If you are a higher rate taxpayer then the benefit is even larger with the same contribution only costing you £60 – it’s an amazingly good deal that makes your money work harder.”
How much is pension tax relief worth?
Even small amounts can snowball over a lifetime of pension saving, boosting your retirement wealth significantly over time. This snowball effect, also known as investment compounding, helps pension tax relief to supercharge your pension savings.
The impact of tax relief on your potential retirement savings is striking.
According to calculations by investment platform interactive investor, someone saving £200 each month for 40 years could end up with retirement wealth worth £395,400. And £79,100 of that wealth would be due to pension tax relief alone, assuming an investment growth of 5 per cent and an annual increase in contributions of 2 per cent each year.
The table below shows the impact of pension tax relief on your retirement savings.
Calculations from interactive investor - assumes basic rate taxpayer paying into their pension for 40 years, 5 per cent investment growth net of fees and contributions increasing at 2 per cent each year in line with inflation.
Monthly pension contributions | Boost from tax relief | Cost after tax | Pension wealth at retirement | Pension wealth due to tax relief |
|---|---|---|---|---|
£100 | £20 | £80 | £197,700 | £39,500 |
£200 | £40 | £160 | £395,400 | £79,100 |
£500 | £100 | £400 | £988,500 | £197,700 |
Because higher-rate taxpayers receive a 40 per cent boost, the effect is even more impressive. Someone saving £200 every month would receive a staggering £158,000 boost to their retirement savings thanks to pension tax relief.
Get a free fractional share worth up to £100.
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Get a free fractional share worth up to £100.
Capital at risk.
Terms and conditions apply.
Do I get pension tax relief automatically?
Thankfully, most pension schemes add tax relief automatically, so you don't have to do a thing. But frustratingly, it’s not that simple for everyone.
Pension savers who pay higher-rate tax could miss out on tax relief as some schemes only pay 20 per cent tax relief as standard. They could be owed a significant tax rebate and need to reclaim the additional 20 per cent.
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Myron Jobson, senior personal finance analyst at interactive investor explains, “For higher-rate taxpayers contributing to a relief-at-source workplace pension scheme, it’s important to note that the extra tax relief isn’t applied automatically - you’ll need to claim it yourself. Additionally, you can claim back any missing tax relief not only for the current tax year but also for the previous three tax years, ensuring you don’t miss out on what you’re entitled to.”
Payments into a personal pension like a SIPP also only attract 20 per cent tax relief. Again higher-rate taxpayers will need to reclaim the additional 20 per cent tax relief through their tax return or by writing to HMRC.
What if you don’t pay tax?
Perhaps surprisingly, it's also possible to benefit from pension tax relief even as a non-earner. So, if you're taking a career break, there's no need to miss out on pension tax relief.
Helen Morrisey says, “You can get tax relief of 20 per cent even if you aren’t earning an income at that time. You can still put up to £2,880 per year into your SIPP and receive the government top up, bringing your contribution to £3,600.”
For couples, it can make sense to keep contributing to a partner’s pension while they’re not earning. Keeping your pension ticking along is a great way to stay on track with your retirement savings.
Are there any limits on tax relief?
With such generous rules, it's no surprise that there are some restrictions on pension tax relief, although the limits are still significant.
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Pension payments are capped at £60,000 each tax year and you can't pay in more than your income in any given tax year. You’re also allowed to carry forward any unused pension allowance from the previous three tax years.
Once you near retirement and start taking a taxable pension income, your contributions are restricted to £10,000 per tax year.
Most of us are unlikely to get anywhere near these limits, but if you fall foul of the rules, you could end up with a tax charge. You’ll effectively have to pay back any extra tax relief received.
As usual, getting ahead of the game and using time as your best friend is key when it comes to retirement planning, so consider your pension contributions now and you could reap rewards in future.
When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
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