I love this simple explanation of how tax-relief works. Far too well written to be by me, the words are from Quietroom’s Vincent Franklin.
The government wants us to save for when we retire. They encourage us through tax relief. If you’re an ordinary rate taxpayer this means putting £1 into your pension scheme only reduces your take-home pay by 80p. If you’re a higher rate taxpayer it reduces your take home pay by even less.
But there are limits to this tax relief. Just as we’re given a luggage allowance at the airport, we’re given a savings allowance by the Government. If we go over this allowance it can cost us.
There are two allowances – annual allowance and lifetime allowance.
Let’s look at annual allowance first. Everyone starts with an annual allowance of £40,000.
If you’re in a defined contribution scheme, where you and your employer are putting money into a pension pot that you’ll use when you retire, this means that between you, you can put up to £40,000 into your pot each year without you having to pay tax on the money that goes in.
If you’re in a defined benefit scheme, where your pension will be based on your salary, it means the value of your benefits can increase by up to £40,000 each year without you having to pay tax on the money that goes in. To find out how much the value of your benefits has increased, speak to your pension provider.
So, everyone starts with a £40,000 annual allowance. But if your income is over £110,000, the amount you and your employer can actually put into your pension scheme without you paying tax on it, goes down. Broadly speaking, your income is all the money you earn, including money from things like renting out a property, but excluding any money you put into your pension or give to charity. For every £2 your income is over £110,000, the amount that can go into your pension without paying tax goes down by £1.
Here’s an example, if your income is £122,000, that’s £12,000 over £110,000. The amount that can go into your pension goes down by £1 for each £2 of that £12,000, so it goes down by £6,000. So, up to £34,000 could go into your pension pot or your benefits could increase in value by £34,000 and you wouldn’t have to pay tax on the money that goes in. But you would pay tax on anything that took it over £34,000.
But no matter what your income, you can always have up to £10,000 go into your pension or your benefits can increase in value by £10,000 without having to pay tax on the money that goes in.
If you think you might go over your allowance, you might want to think about changing your contribution rates.