With the new tax year upon us and clients looking to get the most out of the tax advantages of their pensions, it’s a good time to recap the rules around tax relief on contributions.
Anyone under age 75 who qualifies as a ‘relevant UK individual’ can receive tax relief on personal contributions. To qualify, an individual must meet any one of these criteria:
- They have ‘relevant UK earnings’ for that tax year.
- They are resident in the UK at some time during that tax year.
- They were resident in the UK at some time during the five tax years immediately before the tax year in question, and were resident in the UK when they joined the pension scheme.
- They have general earnings from overseas Crown employment for that tax year.
- They are the spouse or civil partner of an individual who has general earnings from overseas Crown employment for the tax year.
Tax relief can be claimed on personal contributions up to the higher of either that individual’s relevant UK earnings for the tax year, or the basic amount of £3,600.
HM Revenue & Customs’ (HMRC) guidance provides a full list of what constitutes relevant UK earnings. Generally, it includes all earned income taxable in the UK, but not unearned sources like dividends, most rental income, and pension income.
Different pension schemes claim tax relief in different ways.
If the scheme operates ‘relief at source’, they will reclaim 20% basic rate tax relief from HMRC. Anyone paying tax at a higher rate than basic can reclaim further tax via their tax return.
If the scheme operates under ‘net pay’, your client will receive tax relief up-front via a gross deduction of the contribution from their salary, meaning they receive tax relief at their marginal tax rate. Those in net pay schemes with earnings lower than the personal allowance of £12,500, therefore, miss out on tax relief they’re entitled to and would have received automatically in a relief at source scheme. This has been a long-standing anomaly which requires a solution, with the government announcing in the Budget they will consult on this.
To receive tax relief on employer contributions, the employer deducts the contribution as a business expense, resulting in a lower corporation tax bill. No tax relief is claimed by the pension scheme.
To be eligible for tax relief, employer contributions must be made “wholly and exclusively” for the purposes of the company’s trade or profession. Employer contributions aren’t directly tied to earnings, but to meet this test the contribution should form part of the employee’s remuneration package, and shouldn’t be excessive considering the value of work they undertake.
Special consideration is needed for controlling directors and connected employees of a company, but as long as the contribution is in line with what would be paid for an unconnected individual in similar circumstances, the wholly and exclusively test will likely be met.
The annual allowance doesn’t limit tax relief entitlement, but the annual allowance charge effectively cancels out tax relief received on any part of a contribution which exceeds the annual allowance. The charge is calculated at the individual’s marginal tax rate, and applies to both personal and employer contributions exceeding the annual allowance.
So remember, whilst there are no hard limits on how much can be contributed to a pension, there are limits on who can receive tax relief on contributions, and how much.
Bethany Joslyn is technical consultant at AJ Bell