Claire Trott: Which pension tax relief option is best for clients?

Claire Trott discusses the pros and cons of different pension tax relief methods in her latest article for RP. What works best - relief at source or net pay? She also nudges advisers to ensure clients are getting the full benefits they are entitled to

One of the many things I talk to advisers about on a regular basis is how schemes provide tax relief to their members and if there is anything that they have to do to get what they are entitled to.

For a few years now I have been actively encouraging advisers to review their clients’ auto-enrolment schemes to ensure their members are getting the full benefits they are entitled to.

The government has now called for evidence regarding the different types of scheme and the impact on low earners as well as any administration issues that could be improved.

Back to basics

Firstly, let’s look at the basics. What is the difference between net pay and relief at source?

Net pay schemes can sound very misleading because the contributions are paid out of the gross earnings before any tax is deducted. This means that for those that pay tax it automatically reduces their taxable earnings so they will immediately pay less tax. On the flip side, it means that for those that don’t pay tax they won’t benefit from any relief.

This may seem fair but when you consider what happens in relief at source schemes it isn’t fair at all. Lower earners usually need the most encouragement to save because any reduction in take-home pay will have a bigger impact on their finances.

Relief at source means that pension contributions are paid after tax and the scheme will reclaim 20% as standard of the grossed-up amount. So, the member pays in £80 and the contributions will – once the tax relief is received from HM Revenue & Customs (HMRC) – be worth £100.

If the member is a higher or additional rate taxpayer, then they will need to reclaim the remaining 20% or 25% from HMRC directly.

Contrary to many people’s understanding, there is no need to do a tax return if the only purpose is to reclaim higher rate pensions tax relief. It is sufficient to just inform HMRC on the phone and have their tax code adjusted to give the extra relief due. It is important to quote the gross contributions though, so in the example above you would inform HMRC that £100 had been paid.

What’s the right answer?

In a way, there is no right answer for everyone. For lower earners, it makes sense that they are in a relief at source scheme, so they get the tax relief that according to legislation they are due.

However, there is additional administration on the part of the scheme if they have to do the relief at source claims rather than just pay the contributions using the net pay method.

For those who are high earners, moving from a net pay scheme to a relief at source scheme will result in an additional administration burden on the members, with everyone earning over the basic rate band having to make additional reclaims.

We do know that many forget to make these claims, but, if all those that were in a net pay scheme need to now make a claim then surely the system needs to be improved. When trying to adjust my Government Gateway account, should I want to change my pension contributions, it is a real struggle having to go back and calculate the adjustment needed to my tax code. There is nowhere to enter the contributions so calling up is a lot easier. If this was improved, then it would be less of a burden on all.

In my opinion, the one thing that is clear is that it isn’t possible for all schemes to become net pay schemes, mainly because personal pensions don’t have an associated employer who can pay the contributions to the scheme before tax.

Another thing that is clear is that ensuring more lower earners get the incentive to save is more important than making the administration burden less complex.

So where do we go from here?

Well, that is the big question we are being asked in the call for evidence. This is a good time to highlight the issue that pension scheme members, their employers and their pensions schemes have with the current processes. Does one option give all of them the greatest benefits? I am not sure, but it’s important that we have a say in the current problems with the system.

Claire Trott is head of pensions strategy at St. James’s Place Group