Understanding pension tax relief

Why paying pension tax relief can seem like an alien concept

Pension tax relief is one of the major benefits of saving into a pension. Basic rate tax payers can essentially contribute £100 to their pension for just £80. Similarly, if you pay tax at £40%, that £100 pension contribution will only cost you £60.

Governments have tried to limit these benefits and there’s both an annual limit on how much you can contribute to a pension and qualify for tax relief, and a lifetime limit on the total pot that can be built up with the benefit of tax relief. If you breach these limits, you’ll have to pay a tax charge. Both of these limits have been tightened significantly in recent years, with the annual allowance now at £40,000 per year and the lifetime allowance currently at £1.03m.

These may sound like big numbers, but it would be wrong to say these limits only concern the wealthy. The reality is that more and more people are being captured by these limits – for instance, people who may have had long service in a final salary scheme could find themselves breaching them.

Don’t miss out

If you’re getting close to either of these limits, it’s tempting to stop contributing to the scheme in an attempt to avoid the tax charge. However, this might not always be the best thing to do, as you could potentially miss out on many benefits by ceasing contributions. For instance, you may miss out on large employer contributions that would really boost your income in retirement.

In addition, people in danger of breaching their annual allowance may worry about having enough money to pay the tax charge. However, there are instances where the scheme will pay the charge for you.

Royal London has written a guide, Why saving beyond pensions tax relief limits might not be a bad idea, which highlights some of the key issues you should be aware of when making this decision.

Seeking advice

It’s important to note that paying an annual or lifetime allowance charge is not an inherently bad thing. It isn’t a punishment for bad behaviour and it certainly isn’t a sign that you’ve done something unlawful. It’s merely a way for HMRC to claw back overpaid tax relief. As a result, avoiding the charge shouldn’t necessarily be your default position and you should think carefully about whether ceasing contributions to avoid the charge or remaining in the scheme and paying the charge will leave you better off in the long term.

These are complex issues that can have long-term effects on your financial wellbeing, so it’s a good idea to speak to an independent financial adviser before making a decision. They will go through your individual situation and advise you of the best way to proceed. Reading the Royal London guide will also give you an idea of some of the factors an adviser would consider when assessing your circumstances.