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29 May 2021

Pension tax relief issue costing lower earners over £140m: how to boost your pension

The government promised to fix the issue in 2019, but is yet to publish plans to do so

Government delays to making policy decisions on the pension tax system have cost lower earners £142m over the past couple of years, according to wealth management firm Quilter.

In November 2019, the government promised to overhaul the system that penalises low earners in defined contribution (DC) schemes. It published a consultationin July last year to address the anomaly, but it hasn't published an update on its plans since.

Under 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 pension schemes aren't receiving tax relief on their contributions. If you don't pay income tax, it's only available where the pension scheme operates on a relief-at-source (RAS) basis.

Here, Which? looks at how much the anomaly is costing low earners in more detail, and other ways you can boost your pension.

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How does pension tax relief work?

Tax relief is paid on your pension contributions at the highest rate of income tax you pay. So:

  • 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, it would actually only cost you £80.

The government adds an extra £20 on top - what it would have taken in tax from £100 of your salary. Higher-rate (40%) and additional-rate (45%) taxpayers only need to pay £60 and £55 respectively to achieve the same £100 of pension savings.

Relief at Source and Net Pay

There are two ways in which tax relief is provided by the government, depending on the type of scheme you're in. If you're a member of:

  • A net pay scheme: pension contributions are deducted from your salary before income 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 you've paid income 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 will need to submit a self-assessment tax return to receive the extra due to them to make the total tax relief up to 21% in Scotland, 40% (41% in Scotland) and 45% (46% in Scotland).
  • Find out more:how tax relief works on contributions

How much could the anomaly be costing you?

The pensions tax relief issue was first raised in parliament in 2016. Since then, the anomaly has cost savers £265m, and women account for around two-thirds of those impacted, Quilter's analysis shows.

The table below shows how much has been lost in each tax year individually and in total since 2015-16, and how many people missed out.

Tax yearLoss per year (for each individual)
Number of peopleTotal loss per year

Source: Quilter

In the 2020-21 tax year 1.5 million people lost £62.60. While this may not seem like a huge sum, if similar losses were seen over a number of years, it could make a huge difference to someone's total retirement pot.

Quilter estimates that if the system is left alone for another year, the total loss incurred may be a further £95m.

What could a new tax relief system look like?

The government is considering abolishing the net pay method for delivering tax relief, proposing that all DC schemes switch to a method where only a basic-rate tax top-up is paid directly to a member's pot.

In other words, schemes would be required to switch to a RAS method, so that all scheme members would receive 20% tax relief, regardless of whether they pay income tax.

Making these changes would be good news for millions of low earners who would receive more in their pot in retirement.

In Quilter analysis from last year it found that the net-pay anomaly means some workers earning £12,499 a year could retire with a pot worth £59,000 under the RAS scheme, while those in net-pay arrangements would end up with £51,000. This assumes 4% net investment growth after charges in both cases, and a retirement age of 68.

However, it's still not clear if and when the government will announce changes to the system.

A Treasury spokesperson told Which?: 'We are committed to comprehensively reviewing this complex issue, which is why we undertook a call for evidence last year. We are currently considering the responses and potential policy options and will respond in due course.'

How else can I build a pension?

If you're affected and can afford to pay more into your pension, you have other options to grow your pot.

We give some examples below:

Lifetime Isa (Lisa): the lifetime Isa is a tax-free savings or investments account designed to help those aged 18-39 to buy their first home or save for retirement. The 25% government bonus on the lifetime Isa mimics pension tax relief, in that for every £4 you save, the government will add £1 up to a maximum of £1,000 every tax year until you turn 50 years old. It can be a good way to build extra retirement income if you're willing to keep it locked away until age 60, the minimum age you can withdraw.

Personal pension: you can have a personal pension to provide additional retirement benefits, even if you're a member of a workplace pension scheme. Personal pensions work by you paying in a set amount each month to your chosen pension provider. You'll receive a fixed pension pot when you retire, to spend on an annuity or to go into income drawdown. They offer 20% tax relief if you're a basic-rate taxpayer, which they claim back and add to your pot. They also provide a 25% tax-free lump sum on retirement, like workplace pensions.

There are no restrictions on the number of different pension schemes that you can belong to, but there are limits on the total amounts that can be contributed across all schemes each year, if you're to receive tax relief on contributions, known as the pensions annual allowance, which is £40,000 in 2020-21.

Self-invested personal pension (Sipp): aSipp is a do-it-yourself pension. You'll be taking on responsibility for building and managing your own investments, so you'll need to have the time and confidence to do this. The pension 'wrapper' will hold your investments until retirement, at which point it can be turned into income. They are a good option for people who want to gather all of their pensions into one pot before they retire. You get tax relief on contributions up to 100% of your annual salary (to a maximum of £40,000 per tax year).