The Idiosyncrasy of Tax Relief

November 19th, 2008

One of the well known benefits of making a pension contribution is that the contribution you make should receive tax relief. How this is applied depends upon a number of factors including how the contribution is made, the type of scheme it is paid to, how much you contribute and how much you earn.

Within this article we are going to concentrate on one particular aspect of pension contributions and the slight anomaly that exists.  In doing so, we are assuming the person is a higher-rate taxpayer and is making a contribution from their net pay to a personal pension. We will describe the process in detail, how this apparent ‘discrepancy’ happens and how it is possible to overcome this discrepancy. It should be noted that for calculation purposes, National Insurance is being ignored and the amount of contribution is fully subject to higher-rate tax.

Currently, if you make a payment from your net pay into a personal pension scheme the contribution will be grossed up by the pension provider to allow for basic-rate tax (the tax amount will be claimed back from H M Revenue and Customs (HMRC) and credited to your pension plan).  For example:

Assumed gross contribution is £1,000
Net cost from your net income is £800 (£1,000 – 20% basic-rate tax relief)

The amount therefore attributed to your pension fund is £1,000 even though you have only paid £800 from your net pay.

This is straightforward, but a higher-rate taxpayer should be entitled to 40% tax relief on the contributions they make. This is illustrated below:

Assumed gross contribution is £1,000
Net cost from your net income is £800 (£1000 – 20% basic-rate tax relief)
Additional tax relief to be reclaimed personally from HMRC is £200 (20% of     £1,000)
Effective net contribution is £600 (after £400 in total is reclaimed from HMRC)

£800 is therefore paid out of your net pay and a further £200 is reclaimed by you from HMRC (this can be through either a direct refund or a change to next year’s tax code).  This means you have effectively paid £600 which has been grossed up so £1,000 is the total amount in your pension plan

Based on the above everything seems fair and full tax relief at 40% has been received, right?  Well, not necessarily as to be in receipt of a net amount of £800 a higher-rate taxpayer would need to have received income of £1,333.33 gross.  This means that £533.33 has been taken at a 40% tax rate, but the tax relief on your pension is only £400.  So where does the difference go?

The problem is that the 40% tax relief on your pension contribution is based on the gross pension contribution rather than the gross salary which has been taxed in the first place.  As 40% of gross salary in monetary terms will always be higher there will always be this differential.  The only way to square the circle to some degree would be to pay the additional £200 tax relief received on your pension contribution back into your pension, then make a further contribution with the additional tax relief claimed on this and so on and so on…

So the question is what do you want paid into your pension? If you want a lower figure paid into your pension now, but the higher-rate tax relief credited to next year’s pay read no further – however, if you want the true gross amount to go into your pension pot then read on.

The following two ways can ensure that the true gross amount is paid into the plan:

  1. By contributing to an occupational scheme on the net pay basis (this effectively deducts the contribution from your gross pay before tax and National Insurance); or
  2. Enter into a salary sacrifice arrangement with your employer where you agree to give up a portion of your salary and they agree to pay this in to a pension plan on your behalf.  As the salary has been sacrificed this is not subject to tax in your hands as you have given up the rights to the income and your pay is reduced accordingly.

So if you sacrifice £1,333.33 per year your employer will pay this full amount into the pension plan on your behalf.  Your net pay for this year will not be affected (assuming that you would have made a net pension contribution of £800 otherwise).  This does mean that there would be no credit against next year’s pay, but also there is no need to make a tax return in respect of the pension contribution and the full amount is credited this year.

Other advantages to salary sacrifice include both you and your employer saving National Insurance (which could be paid into the pension also!) and as your salary is reduced then entitlement to other tax credits may increase.  This may also become more advantageous following the announcement in the Pre-Budget Report that from April 2011 the Income Tax rate on income over £150,000 will be 45% and National Insurance will increase by 0.5%.

But there can be disadvantages including a potential reduction in benefits and State 2nd pension entitlement, a reduced salary figure to use for loan and mortgage applications and a reduced death in service.

As you will appreciate this article is merely a basic overview of what is a complex issue and should not be acted upon without prior advice from a professional.

The value of your investment and income from them can go down as well as up and you may not get back the full amount invested.  Levels and bases of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor.