Pension Schemes
1 Types of pension scheme
There are tax advantages associated with pension scheme investments. A registered pension scheme is a long-term savings plan for retirement with special tax privileges.
the individuals who invest are entitled to tax relief for the contributions they make into the scheme limited to the higher of (gross amounts):
the relevant earnings of the taxpayer, being employment income and/or trading profits, or
£3,600
An employer who contributes into a pension scheme on behalf of their employees can deduct those contributions from their trading profits. These contributions are an exempt benefit for the employees.
However, this amount will be included to determine whether the annual allowance has been exceeded (see later).
1.1 Personal Pension Scheme
Run by financial institutions - an insurance company or a bank
available to the employed, self employed or unemployed individuals
if the individual is an employee, contributions can be made by the employee and/or the employer
1.2 Occupational Pension Scheme
Set up by the employer for the benefit of employees
contributions can be made by the employee and/or the employer
2 Tax relief
Regardless of the type of scheme the amount of tax relief available for the contributions is the same, but depending on the type of scheme. The method of obtaining the relief is different.
When an individual contributes into a personal pension scheme, then as we saw in Chapter 2, no such deductions are made from income in the Income Tax computation, instead tax relief is given as follows:
basic rate tax relief is given at source on the lower of:
gross contributions paid
maximum annual amount - the higher of £3,600 or 100% of relevant earnings
This means that if a taxpayer pays £8,000 into his personal pension scheme, this is net of basic rate tax at 20%. HMRC will then pay the pension provider an amount equivalent to the basic rate deduction (20/80 x £8,000= £2,000). Thus the individual’s pension fund is increased by £10,000 in total. As the gross contribution exceeds £3,600 (see note above) then the taxpayer must have net relevant earnings for the tax year of at least £10,000 for tax relief to be fully available.
Higher rate and additional rate taxpayers achieve higher and additional rate relief by extending the basic and higher rate bands by the gross amount of the personal pension contribution (in the same way as gift aid donations*).
*Note that gross personal pension contributions are also deductible to determine 'adjusted net income' for the purposes of tapering the personal allowance and for the child benefit tax charge (in the same way as gift aid donations).
When an employee makes a contribution into an occupational scheme tax relief is given at source under the “net pay arrangement”. The employer will deduct the gross contribution from the individual’s employment income before computing the tax to be deducted under PAYE.
If an employee has a gross annual salary of £25,000 and wants to contribute £1,200 into his occupational pension scheme, The employer, over the tax year, will pay £1,200 into the pension scheme on the employee's behalf and put a (net pay) salary of £23,800 through PAYE.
This would be presented in the calculation of employment income in the Income Tax computation as a salary of £25,000 less employee's occupational pension contribution of £1,200.
3 Annual Allowance (AA)
Although tax relief is available on pension contributions up to the amount of relevant earnings for a particular tax year, the AA acts as an overall annual limit for total gross pension contributions.
Where tax relieved contributions (paid by the individual and (potentially) the employer, the total of which are known as 'Total Pension Inputs') are paid in excess of the AA (including any brought forward unused allowances (see below)), then there will be an annual allowance charge (see section 4). This charge is subject to income tax at the taxpayer's marginal rate.
TPI > AA = AA charge.
The AA for each year is £60,000 (up to and including 2022/23 it was £40,000). This information will be provided in the tax rates and allowances section of the exam paper.
If the AA is not fully utilised in any tax year, and the taxpayer was a member of a pension scheme in that year, it is possible to carry forward any unused amount of the AA for up to 3 years. Pension contributions made in a tax year will firstly use the AA of that tax year followed by the unused AA of the previous 3 tax years, used on a FIFO basis. If in any year an individual is not a member of a pension scheme, the annual allowance is lost.
Moira and Nigel have made the following gross personal pension contributions:
Moira | Nigel | |
|---|---|---|
£ | £ | |
2022/23 | Nil | 40,000 |
2023/24 | 52,000 | 39,000 |
2024/25 | 48,000 | Nil |
Moira was not a member of a pension scheme for the tax year 2022/23 so her annual allowance for that year is lost, but Nigel was a member of a pension scheme for all 3 years.
Moira
Moira has unused allowances of £8,000 (£60,000 – £52,000) from 2023/24 and £12,000 (£60,000 – £48,000) from 2024/25, so with the annual allowance of £60,000 for 2025/26, a total of £80,000 (£60,000 + £8,000 + £12,000) is available for 2025/26.
Nigel
The annual allowance for 2022/23 is fully utilised with the payment of £40,000. However, Nigel has unused allowances of £21,000 (£60,000 – £39,000) from 2023/24 and £60,000 from 2024/25, so, with the annual allowance of £60,000 for 2025/26, there is a total of £141,000 (£60,000 + £21,000 + £60,000) is available for 2025/26.
Restriction of the annual allowance for high income individuals
The normal annual allowance of £60,000 is gradually reduced for individuals with high income; i.e. where adjusted income exceeds £260,000.
Adjusted income is net income PLUS
any employee contributions to occupational pension schemes which will have been deducted from employment income in calculating net income,
any employer contributions to either occupational or personal pension schemes.
Where adjusted income exceeds £260,000, the annual allowance for that year is reduced by half the excess:
(adjusted income - £260,000) x 50%
The annual allowance cannot be less than £10,000
For the tax year 2025/26, Juliet's only taxable income was employment income of £290,000 which is stated after a contribution to her employer's occupational pension scheme of £10,000. Her employer paid 16,000 into the same scheme.
Julia's adjusted income is £(290,000 + 10,000 + 6,000) = £306,000
Juliet’s tapered annual allowance for 2025/26 is calculated as follows:
£(60,000 – ((306,000 – 260,000) x 50%)) = £37,000.
If you are asked to do this calculation in the exam then show all the workings.
Ashton made the following gross contributions into his pension scheme in earlier tax years:
2022/23 | £62,000 |
2023/24 | £50,000 |
2024/25 | £45,000 |
Ashton has an annual salary of £120,000.
Calculate Ashton's annual allowance for 2025/26.
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4 Annual Allowance Charge
As stated above, although tax relief is given on pension contributions up to the level of relevant earnings of the taxpayer for a tax year, the annual allowance is effectively the annual limit.
If the tax relieved contributions (made by the employer and the employee) exceed the AA (including any unused allowances brought forward) there will be an AA charge, chargeable to income tax at the taxpayer’s marginal rate(s).
Excess contributions are:
taxed as if extra income was received
taxed after dividends at the non-savings rates, and
this AA charge is added to the individual’s income tax liability.
Therefore, excess contributions suffer tax as follows:
those that fit into the unused basic rate band suffer tax at 20%
any remaining excess contributions that fit into the unused higher rate band suffer tax at 40%
any contributions in the additional rate band suffer tax at 45%.
5 Taking a pension
When the taxpayer takes their pension, a tax free lump sum of 25% of the value of the pension fund (up to a maximum of £268,275) may be taken and whereas previously the remainder would have to be used to buy a pension annuity, the taxpayer may now withdraw the balance of the pension fund as taxable income whenever they wish.