What does tax relief really mean? Explaining the pension superpower you need to know about

Less than a third of us understand how our pensions are added to by the tax system.

Research by Hargreaves Lansdown found that less than a third of people, or just 31 per cent, could identify the purpose of pension tax relief.

“Pension tax relief is an important incentive to encourage people to save for retirement, but the majority of people don’t know what it is,” says Helen Morrissey, head of pensions analysis at Hargreaves Lansdown.

“We need to raise awareness of this unsung hero of retirement to help people make the most of their retirement savings and save them from nasty surprises.”

What does ‘relief’ mean and how much money will I receive?

When you pay into your pension, some of the income tax that would normally go to the Treasury is directed towards your pension.

For a basic rate taxpayer, earning £100 would normally mean £20 going towards income tax and £80 being transferred to your bank account. If you put that £80 into your pension, the Treasury adds the missing £20 will set the total contribution back up to £100.

The effect of this is that your pension increases before the money is even deposited.

“I think the word ‘relief’ is probably causing the understanding issue; it’s quite vague,” says Becky O’Connor, PensionBee’s public relations manager, suggesting something more specific such as “tax-free pension contribution” would have been clearer.

“Whatever you call it, it’s vital to grasp this because if you don’t, you won’t truly understand the magic of pensions and why they’re so perfect for long-term savings.”

How does my tax bracket affect my retirement savings?

How much income tax you pay affects how much money you get from the Government when you contribute to your retirement.

Basic rate taxpayers pay income tax at 20%, so they would need to pay £80 to add £100 to their pension; The government adds the remaining £20.

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High rate taxpayers pay 40% income tax, so a £100 pension contribution would cost them £60, with the government adding £40.

Additional rate taxpayers pay 45% income tax; This means a £100 contribution would cost them £55, of which £45 would come from the government.

There is a limit

There is a limit to how much of this tax boost you can receive each year.

Pension contributions qualify for an annual allowance of up to £60,000, or 100 per cent of your earnings if you earn less than this. Very high income earners may also face a lower benefit.

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“You can even use a process called ‘carry forward’ to increase your contribution by taking advantage of unused annual allowances from the previous three tax years,” says Morrissey.

“It’s an extremely tax-efficient way to make the most of your long-term savings.”

You don’t need to win to claim

You can also benefit from this system even if you do not earn or pay income tax.

If you have a Self-Invested Personal Pension (SIPP), you can still pay up to £2,880 a year and the government will top this up to £3,600.

“Parents and grandparents can help them get a head start in retirement by saving on behalf of their children and grandchildren,” says James Scott-Hopkins, founder of financial planning firm EXE Capital Management.

Children can have SIPPs and the government will also contribute up to £720 a year. If an adult pays £2,880 a year each year from birth to age 18, they will give the child £64,800, but with tax relief the government will have added a further £12,960.

Pension tax refunds are not always automatic

One of the most important things for higher and additional rate taxpayers to understand is that the extra tax refunds to which they are entitled are not always automatically applied.

Basic rate income tax is usually added to your pension without you having to do anything. Pay £80 and £20 will appear in your account from HMRC.

However, higher and additional rate taxpayers need to take action to reclaim the extra tax they are due, usually through their tax return.

Antonia Medlicott, founder of Investing Insiders, says it is “routinely under-owned” because people don’t understand how the system works.

There are exceptions though. If your pension contribution is deducted from your salary before tax is calculated, the full tax refund is automatically applied.

As the tax filing deadline approaches the end of January, higher and additional rate taxpayers need to check how their extra tax refunds are being applied to their pensions.

“If you don’t ask for it, then it doesn’t magically come. It just disappears,” says Medlicott.

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