Why paying into a pension fund is so tax efficient
Paying into a pension fund is one of the most common pieces of advice you may receive from an accountant on ways to save on tax. Continue to read to find out how and why, but be mindful that if you are considering doing so, then you should make every effort to pay into a fund before 4th April 2023 in order to receive the benefit for the tax year 2022/23.
What are the benefits of paying into a pension fund?
The UK government offers incentives for people to pay into their pension fund; this is to encourage more people to prepare and save for the future. The main benefit in doing this is that the government will also add to your pension pot on top of what you have put in yourself. For higher rate tax payers and additional rate tax payers, there is the added benefit of tax relief from their income tax.
How much will I receive if I pay into my pension fund?
For the tax year 2022/23, the government will pay more on top of what you put into your pension fund yourself. By paying in £80 to your pension fund, it will grow to £100, as the Government will contribute £20 on top of your contribution. In this scenario, £80 is considered “net” and £100 is considered “gross” – you’ll get 25% on top of the net amount you pay in, but relief is usually expressed in terms of gross contributions. i.e. the Government’s top-up is 20% of the gross.
What tax relief do I receive for paying into my pension fund?
Tax relief is available to higher and additional rate tax payers. For the tax year 2022/23 it is calculated as follows, based on gross pension contributions:
- Higher rate tax payers who currently pay 40% income tax will receive the 20% contribution into their pension fund as described above, and 20% as tax relief from their income tax bill – which they will have to claim via a self-assessment tax return.
- Additional rate tax payers who currently pay 45% income tax will also receive the 20% contribution into their pension fund as described above, and 25% as tax relief from their income tax bill – which they will have to claim via a self-assessment tax return.
If you fall into the higher or additional rate tax payer category then you can further take advantage of the tax relief available. Should you wish to pay enough into your pension scheme you can effectively lower your personal income tax bracket into the band below, meaning that the remainder of your income will be taxed at a lower percentage.
For example, if you are a higher rate tax payer who earns £50,000 per year, you could choose to pay £4,000 into your pension fund. The government would supplement this with an additional £1,000 as explained above. This would therefore take all your income into the basic rate tax bracket and you would only be taxed at 20% instead of 40%.
How much can I pay into my pension fund?
You can pay a maximum of your full annual earnings*, but this is capped at £40,000 per year. The £40,000 limit also includes any contributions from a workplace pension scheme which you may be enrolled in. So, if you earn £35,000 per year, you could put this full sum into a pension fund so long as no more than £5,000 is being put in from other sources. However, if you earn a salary of £50,000 per year, then the maximum you could put in is £40,000 (again, including any contribution from other sources).
On top of this annual allowance, there is an overall lifetime limit. This is only relevant for the highest earners. For the tax year 2022/23 the maximum amount is set at £1,073,100. This means that the sum of your entire pension fund can reach this limit before no further tax relief will be available on contributions that go over this amount.
There is always the option of carrying forward any unused pension allowance. If you did not use the maximum allowance from the previous three tax years, then you may include that amount in your current tax year to pay in more than £40,000 and still receive the tax relief.
This article has been written for informative purposes only. If you require specific advice regarding your pension we would recommend that you contact a financial advisor. We are not authorised by the Financial Conduct Authority to offer specific investment advice.
* for directors of their own limited company, full annual earnings only applies to salaried earnings and not dividends.