Pensions tax relief rates under review: how could the rules change?

Pensions tax relief rates could be overhauled, as the Treasury has launched a consultation to address an anomaly that penalises low earners in defined contribution (DC) schemes.

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.

The government wants to know whether it should address the discrepancy for low earners by introducing new measures to include tax breaks for all pension savers.

Here, Which? explains how tax relief works in more detail and looks at how the system could be overhauled.

How tax relief works

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.

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 could the system be reformed?

The government is considering abolishing this 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.

Quilter head of retirement policy Jon Greer says: 'At first glance, it appears the government is leaning towards mandating the use of relief at source for all defined contribution schemes. This certainly has appeal, as there isn't an extra lag between the pension contribution being made and receiving a bonus.'

• Find out more: how DC pensions work

Would changing the rules benefit all savers?

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

Lizzy Holiday, head of DC master trusts and lifetime savings at the Pensions and Lifetime Savings Association, says: 'The publication by the government of a call for evidence on the net pay/relief at source issue shows long-overdue progress towards fixing thetax anomaly that is leaving 1.75 million of the lowest-paid pension savers in “net pay arrangements” worse off.

'On the minimum auto-enrolment contributions [which is 3% for employers and 5% for employees], those affected are losing up to a total of £63 a year each, and in many schemes it can be at least double this figure. Of the affected population, over 75% are female.'

According to Quilter, 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.

Higher earners

However, if net pay schemes are abolished it would mean that millions of higher earners could lose automatic tax breaks on their contributions and would have to reclaim pensions tax from HMRC above the basic rate.

If people fail to fill out a self-assessment, they could be missing out on additional tax relief they're entitled to.

• Find out more: pension tax tips for your self-assessment return

How much tax relief can I earn in 2020-21?

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

It has been set at £40,000 for the tax year 2020-21. 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 unusedallowances from the previous three years, as long as you were a member of a pension scheme during those years. Find out more in our annual allowance guide.

You can use our pensions tax relief calculator to find out how much you could get.