When you pay money into a pension, in most cases you’ll get tax relief. That means that the government pays some of the money you would normally pay as tax into your pension. That means if you’re a basic rate taxpayer, you’ll get an extra £20 for your pension for every £80 you pay in (making £100 in all). Here’s how it works:
Tax relief on pension contributions
If you pay money into your pension, the government gives you tax relief, which is essentially an extra contribution on top of your payments. Tax relief works like this:
- If you’re a basic rate taxpayer: if you pay £80 into your pension every month, the government gives you tax relief which means that your contributions are topped up by £20, so £100 is paid into your pension.
- If you’re a 40% rate taxpayer: if you pay £60 into your pension every month, the government gives you basic rate tax relief (so £80 goes into your pension) and you can claim back the rest through your self assessment tax return. It means your contributions could be topped up by £40 in all.
- If you’re a 45% rate taxpayer: if you pay £55 into your pension every month, the government gives you basic rate tax relief which means that your contributions are topped up by £20, and you can claim the rest back through your self assessment form, so £100 could be paid into your pension. However, there are restrictions in that if your income is over £150,00, your annual allowance (which is 100% of your earnings up to a maximum of £40,000 in tax year 2017 – 18) is reduced by £1 for every £2 you earn over £150,000, up to a maximum of £30,000. So
SAVVY TIP: Be aware that some workplace pensions will give you all the tax relief if you’re a 40% rate taxpayer (not just basic rate tax relief).
What you give up in return for tax relief
Getting tax relief is an effective way of increasing the money that goes into your pension, but it does come at a ‘price’. There are two main restrictions on money you take out of your pension:
- You can’t get access to money in your pension fund before the age of 55 and there are very few exceptions to this. You can get early access to your pension if you are terminally or seriously ill. However, you can’t cash in your pension before the age of 55 if, for example, you’re in debt or want to borrow money.
- You can only take 25% of it tax-free and the rest of the money you take out is taxable. From April 2015 you’ve been able to take out as much money as you want, but only 25% of the amount you take out will ever be tax free.
What to think about
There’s an old saying in investments which is that ‘you shouldn’t let the tax tail wag the investment dog’ — namely that you shouldn’t make a decision about a long term investment because you’ll save tax. That applies to pensions as it does to anything else.
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