Pension tax relief: how to get £35,000 of free money

Saving into a pension, and taking advantage of tax relief, can be extremely rewarding

If you were offered a bank account where for every £80 you put in, £20 would be added, you’d open it in a heartbeat. That proposition exists – it’s your pension, but many of us aren’t taking advantage of it.

Thanks to tax relief, when you pay money into your pension the government immediately tops it up too – this is free money that will be missed out on if you don’t save into a pension. The idea is the money you are paying into your pension has been taxed as income when you earned it – the government simply gives you that tax back when you put money into a pension. It’s an incentive to get people to save for their retirement.

Let’s say you want to put £100 into your pension. When you earned that £100 – assuming you are a basic-rate taxpayer – you had to hand over £20 of it in income tax. So, in order to put £100 into your pension, you are only required to pay in £80, as the government will add the £20 it took in income tax. If you are a higher, or additional, rate taxpayer you can claim back the rest of the income tax you paid on pension contributions via your tax return.

The good news doesn’t stop there. Your tax relief is added to your pension savings immediately, so it can grow alongside the rest of your pot. Plus, any growth in your pension investments is tax-free.

That means if you are 30 years of age now and you want to have a £500,000 pension pot when you retire aged 67, you only need to pay in £320 a month. Over the 37-year period the government will add £35,520 and, assuming a 5% growth rate, you’ll have £512,000 when you turn 67. If you have a workplace pension scheme your employer will contribute too, making your final pension pot even bigger.

Tax relief doesn’t just help long-term retirement savings; it can also be a real bonus for anyone approaching retirement age. If you want to do some last minute saving you can still put money into your pension and get an immediate 20% uplift thanks to tax relief. Add that to the fact you can withdraw 25% of your pension savings tax-free once you are over 55, and a pension can be an incredibly tax-efficient savings vehicle for later life.

Sadly, there are limits on how much tax relief you can enjoy. Each year you can put the equivalent of your annual income, or £40,000, whichever is lower, into your pension and claim tax relief. If you earn less than the personal allowance, and therefore pay no income tax, you still get relief on your pension contributions but your annual contribution limit is lower – £2,880. Over a lifetime, if your pension pot grows to be worth more than £1 million, then you will receive no more tax relief and could have to pay a tax charge.

You can continue to save into a pension even after you retire, up to the age of 75, and still benefit from tax relief, but once you have accessed your pension the maximum you can contribute to your pension reduces to £4,000 each year.

With an annual limit of £40,000 each year, that means there is £8,000 of tax relief up for grabs annually for basic rate taxpayers, and even more for higher and additional rate taxpayers. So it’s safe to say that saving into a pension can be very rewarding.