With just a few days to go until the new tax year begins, it’s your last chance to make the most of your pension allowances and tax relief to maximise your retirement savings.
In particular, if you’re a higher earner, considering retiring soon or already drawing money from your pension, you should take stock now to avoid missing out on tax-free cash or paying unnecessary tax.
Here, Which? looks at five mistakes that could leave less in your pocket at retirement, and explains how to avoid them.
1. Missing out on valuable tax relief
When you save into a pension, the government will give you a bonus as a way of rewarding you for saving for your future. This is known as pension tax relief.
When you earn tax relief on your pension, some of the money that you would have paid in tax on your earnings goes into your pension pot rather than to HMRC.
Tax relief is paid on your pension contributions at the highest rate of income tax you pay. So:
- Basic-rate taxpayers get 20% pension tax relief
- Higher-rate taxpayers can claim 40% pension tax relief
- Additional-rate taxpayers can claim 45% pension tax relief
In Scotland, the pension tax relief follows the Scottish income tax bands, which are slightly different.
You’ll need to check with your pension scheme to see which method it uses for tax relief, as you may need to do some extra work to get the full tax relief you’re entitled to.
There are two main ways to claim:
Pension tax relief from net pay – You won’t have to do any extra leg work if your scheme uses the ‘net pay’ arrangement. Pension contributions are deducted from your salary before income tax is paid on them and your pension scheme automatically claims back tax relief at your highest rate of income tax.
Pension tax relief at source – This applies to all personal pensions and some workplace pensions. If you’re paying into a pension through your employer, your employer will take 80% of your pension contribution from your salary. Your pension scheme then sends a request to HMRC, which pays an additional 20% tax relief into your pension. Under this system, higher and additional-rate taxpayers must complete a self-assessment tax return to receive the extra relief due to them to make the total tax relief up to 40% (41% in Scotland) and 45% (46% in Scotland).
- Find out more: how pensions tax relief works
2. Delaying pension payments
If you’re unsure where to invest your pension, don’t delay paying in for this reason. You can still pay into a pension and get tax relief before the 5 April deadline.
Remember, you don’t have to make investment decisions on your own, unless you want to via a self-invested personal pension.
The important thing is to hold money in cash within your pension. Then when you’re ready to invest, you can move it into your chosen investments.
3. Forgetting about unused annual allowance
The government places a cap on the amount you can save into a pension every year, upon which you can earn tax relief. This cap is known as the ‘annual allowance’, which is £40,000 in the 2020-21 tax year, or 100% of your income if you earn less than £40,000.
If you haven’t used up your annual allowances from previous years, you don’t lose them completely. A process called ‘carry forward’ allows you to make pension contributions to fill up any unused allowance you might have from the previous three tax years.
There are two conditions you need to satisfy to use carry forward. First, you must earn at least the amount you wish to contribute in total this tax year (unless your employer is making the contribution). Second, you must have been a member of a UK-registered pension scheme (this does not include the state pension) in each of the tax years from which you wish to carry forward.
The deadline to carry forward any unused allowance from the 2017-18 tax year is looming. If it is not used by 5 April 2021, it will be lost forever.
- Find out more: how the pensions annual allowance works
4. Triggering the tapered annual allowance
Higher earners need to be aware of the ‘tapered annual allowance’ which kicks in when your threshold income (annual income before tax, minus personal pension contributions) is over £200,000 and your ‘adjusted income’ (yearly income before tax, including personal and employer pension contributions) is over £240,000.
Exceeding your annual allowance will mean that you do not receive pension tax relief on any contributions over the cap and you’ll be faced with an additional tax bill called the ‘annual allowance charge’.
The table below shows how your annual allowance currently reduces as your income increases above £240,000.
|Total adjustable income||Annual allowance|
For those with total income over £300,000, the annual allowance gradually falls from £10,000 to £4,000 for anybody earning in excess of £312,000.
- Find out more: how much will I need to retire?
5. Dipping into your pot and cutting your annual allowance
If you’ve started to draw money from your pension (beyond the 25% tax-free lump sum), your annual allowance for saving into a pension tax-free will fall to £4,000.
This is called the money purchase annual allowance, or MPAA, and applies to people who have taken money from a money purchase, or defined contribution, pension.
HMRC figures, analysed by Just Group, show more than 1,000 pension savers every working day became subject to the MPAA last year by taking their first taxable pension payment from a defined contribution scheme.
The group found that 260,000 pension savers took a taxable pension payment in 2020, meaning that a total of 1.6 million people have been subject to the ‘stringent’ tax rules in the five years since they were introduced.
If you have triggered the money purchase annual allowance, you can’t carry forward any unused allowances from previous years to boost the amount you can pay into your pension.
- Find out more: should I take out lump sum payments from my pension?