Pension tax change to boost take-home pay for low earners

Around 1.2m workers on lower incomes will receive a boost to their take-home pay from 2025, as the government fixes a quirk in the pension tax system. 

The change mainly concerns those who earn more than the auto-enrolment trigger of £10,000, but less than the personal allowance of £12,570. 

Under the current rules, the government tops up pension contributions in the form of tax relief, and the amount you get is equivalent to the rate of income tax you pay. 

However, many of the lowest earners who aren’t paying income tax in certain ‘net pay’ workplace schemes aren’t receiving tax relief on their contributions.

The government committed to fixing this in the 2021 Autumn budget, and has now published legislation into how this will work. 

Here, Which? explains who the change in law will impact, and what the effects are on take-home pay.  

How does pension tax relief work?

Tax relief is paid on your pension contributions at the highest rate of income tax you pay - note that income tax rates and thresholds are different in Scotland.

• Basic-rate taxpayers get 20% (in Scotland, Intermediate taxpayers get 21%) pension tax relief.
• Higher-rate taxpayers can claim 40% (41% in Scotland) pension tax relief.
• Additional-rate taxpayers can claim 45% (46% in Scotland) pension tax relief.

For example, if you're a basic-rate taxpayer and were to contribute £100 from your salary into your pension, with pension tax relief the contribution would only cost you £80.

The tax relief is paid in two ways, depending on the type of scheme you're in. 

If you're a member of:

• A net-pay arrangement (NPA): pension contributions are deducted from your salary before tax, and your pension scheme automatically claims back tax relief at your highest rate of income tax.
• A relief-at-source (RAS) scheme: pension contributions are paid after tax. Your pension scheme will send a request to HMRC, which will pay 20% tax relief into your pension. Intermediate, higher and additional-rate taxpayers need to submit a self-assessment tax return to receive the extra tax relief they're due.

Find out more: pension tax relief explained

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NPA savers miss out 

Since 2015, people saving for their pension through an NPA have had less take-home pay compared to those on the same salary who use an RAS scheme.

This is because those using the latter type of pension scheme receive a 20% top-up from the government on what you save, while those using NPAs receive tax relief at their marginal rate – 0%.

The pensions tax relief issue was first raised in parliament in 2016. Since then, the anomaly has cost savers millions, and women account for around three-quarters of those impacted.

An analysis from wealth management firm Quilter found that in the 2021-22, 1.5m people lost £63.30 because of the rule. 

• Find out more: six pension must-dos for 2022

How will the pension tax changes work?

The Treasury set out an example of how the changes will work: 

Alex and Sam are two employees who earn below the personal allowance (£12,570).

Alex and Sam both pay £500 into their pension scheme, but Alex uses NPA and Sam uses RAS. 

Alex has the full £500 contribution deducted from his earnings before paying any tax. He does not have to use any of his personal allowance in order to pay his pension contributions out of untaxed income. 

Once his pension contribution is deducted, the rest of his earnings are taxed, but there is no income tax to pay. All of the £500 deducted from his earnings goes into the pension scheme. 

Meanwhile, Sam has no tax to pay on her earnings as they are below the personal allowance. The equivalent contribution is paid to her pension scheme as if she had basic-rate tax at 20% deducted from her full £500 contribution. 

Out of £500 earnings, £400 is paid into Sam’s RAS pension scheme as a contribution.

Although no tax has been paid, the pension provider is still entitled to claim £100 in tax relief from HMRC, so Sam will have £500 paid into her pension savings. 

Both Alex and Sam have £500 in their pension scheme. Alex has had £500 deducted from his earnings but in this case, Sam has only had £400 deducted from her earnings, so she has more money in her pay packet, but she has used up more of her personal allowance to make contributions out of her untaxed earnings. 

From 2025, Alex would be eligible for a top-up of £100 to be paid into his bank account - so his pension savings will also have grown by £500, but he'll have only paid £400.

How much will take-home pay increase?

The government estimates around 200,000 low income workers will see their take-home pay rise by £100, while the average worker will see wages rise by £53 extra a year. It said women make up 75% of those who'll benefit from the changes. 

When the changes are introduced, 1.32m people will be eligible for the top-up.

• Find out more: women need to work till 83 to plug the gender pension gap 

How do you sign up?

Eligible workers will not need to confirm their entitlement for pension tax relief, as HMRC will identify you based on information it already holds. 

However, you will need to confirm or provide your bank details via a digital service for the top-up payment to be made.

The money will be paid straight into your bank account - rather than your pension - from 2025. 

The aim of this is to reduce the tax burden on workers, employers and pension schemes, as an individual's tax position will only be known after the tax year ends. Paying the top-up into someone's pension runs the risk of payments being made to people who may not end up being eligible for them. 

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Pension savers will have to wait

Although the change has been welcomed, some have been critical that it will not apply until the 2024-25 tax year - with workers continuing to lose millions of pounds until it comes into force.

Jon Greer, head of retirement policy at Quilter, says: ‘This solution also creates a risk of delay between the pension contribution being made and receiving the top-up. 

‘It’s been a long road to get to this point, and there are still some miles to go before this quirk in the pension tax system is finally addressed.’

We understand the time lag is due to the complex nature of the IT changes required to bring about the changes.

• Find out more: how much do you need to retire?

How much tax relief can I earn in 2022-23?

The government puts a limit on the amount of pension contributions you can earn tax relief from. This is called the pensions annual allowance.

It has been set at £40,000 for the tax year 2022-23. 

Any pension payments you make over the £40,000 limit will be subject to income tax at the highest rate you pay.

However, you can carry forward unused allowances from the previous three years, as long as you were a member of a pension scheme during those years.

• Find out more: pension tax relief calculator

Should you cut your pension contributions?

With costs rising across the board, it may be tempting to cut your pension contributions right now - particularly if you're on a lower income and your finances are being stretched.

However, while this could be a quick win for your short-term finances, it will have consequences when you come to retire. 

What's more, you could be giving up more money than you think - such as the tax relief and employer contributions. 

Check out our news story on the steps you should consider before cutting contributions, and listen to our podcast.