UK Pension Tax Relief

A person who has reached the State pension age still pays tax where income, including the State pension, exceeds the annual personal allowance. This is likely to be the case where a person is receiving the State pension and a company or personal pension, subject to other circumstances. The taxpayer should complete the pension coding form P161 and send this to the tax authorities to ensure that they are taking into account all the allowances due. After reaching the State pension age, a person no longer needs to pay national insurance contributions.

Tax relief for pension scheme contributions

A person paying money into a pension scheme may receive tax relief on the payments made. To obtain tax relief for pension contributions, an individual must have earnings in a tax year (the year to 5 April) that are chargeable to UK tax and must be resident in the UK at some time during the tax year. Tax relief is given on contributions into a registered pension scheme by the scheme member or by a third party on behalf of the scheme member, however no relief is available for contributions made by an employer or for contributions made when the individual is over 75 years of age. The maximum tax relief available is the greater of £3,600 or the UK taxable earnings for the year.

Depending on the type of scheme of which the taxpayer is a member, tax relief may be given in different ways. When tax relief is given at source, a member of a pension scheme pays contributions net of 20% basic rate tax. When the taxpayer is liable to higher rate tax on income, further tax relief is given by extension of that taxpayer’s basic rate band by the amount of the gross pension contributions. Where the pension contributions exceed the maximum amount on which tax relief can be claimed, the excess contributions are treated as if they are gross contributions, from which no tax has been deducted.

Where “net pay arrangements” apply, the employer deducts the pension contribution from the employee’s pay before deducting tax under the pay as you earn (PAYE) scheme. This effectively gives income tax relief on the amounts paid to the pension scheme, but not relief from national insurance contributions as these are charged on the basis of salary before deduction of pension contributions.

If deduction at source and “net pay arrangements” do not apply, tax relief can be given by deduction of the amount of pension contributions from the total income of the taxpayer when calculating the taxpayer’s annual income tax liability.

Pension contributions by employers

Where pension contributions are made by an employer to a registered pension scheme wholly and exclusively for the purposes of the employer’s trade, they are deductible in computing the employer’s business profits for tax purposes. An employer’s contributions to a scheme relating to an employee are not taxable on the employee. There is no limit on the amount of contributions an employer can make to a registered pension scheme.

However where there is a large increase in an employer’s contributions from one year to another, the contributions may not all be deductible in the tax period in which they are paid. Instead, contributions in this situation must be spread over a number of years for tax purposes.

Where the contributions made in the current period exceed 210% of those in the previous period, there is an excess of contributions that needs to be spread. The excess is calculated as the contributions made for the current period minus 110% of the contributions for the previous period. If this amount is more than £500,000 spreading of contributions applies.

Where the excess is between £500,000 and £999,999 tax relief is spread over the current period and the following period; for an excess between £1,000,000 and £1,999,999 relief is spread over the current period and the following two periods; and for an excess above £2,000,000 the tax relief is spread over the current period and the following three periods. If a new scheme has been set up in the current period, so there were no contributions for the previous period, this spreading of reliefs does not apply.

Annual allowance charge

If an individual’s total contributions to pension schemes in a tax year (known as the pension input amount) exceed the “annual allowance charge” of £255,000 for 2010/11, a charge to income tax arises on the individual. The excess over the annual allowance is taxed on the individual at 40%.

In the case of a money purchase scheme, the pension input amount is the total contributions of the employee to that pension scheme, together with any employer contributions. In the case of a defined benefits scheme, the pension input amount is the increase in the person’s pension rights under the scheme during the pension input period ending during the tax year. For this purpose the value of the defined benefits scheme at the end of each period is taken to be the value of any lump sum that would be payable plus ten times the amount of pension that would be payable annually, if the pension were taken by the taxpayer at that date.

Lifetime allowance charge

The “lifetime allowance charge” arises when pension benefits crystallise, if they exceed the lifetime allowance. Benefits will crystallise for example when a scheme pension begins to be paid to the scheme member. The benefits are compared to the lifetime allowance, or the remaining unused portion of the allowance, and any excess is then charged to income tax. The lifetime allowance is £1,800,000 for 2010/11. Where the crystallised pension benefits exceed this amount, the excess is charged to tax at 25%, or at 55% if the amount is taken as a lump sum.


HM Revenue and Customs

“Taxation” by Alan Melville, fifteenth edition, FT Prentice Hall 2010