Understanding your pension tax allowance

Pensions continue to be a tax advantageous vehicle for investment, initiated by the government to encourage people to save for their retirement. It is helpful to understand how the tax relief works so as to be able to put it into context with your own situation and make the most of the allowances available to you.

The first thing is that contributions have to be paid into a registered pension scheme. From here, the level of tax relief depends on whether the pension is classified as occupational, public service or private.

Occupational pension schemes are typically deducted at source before applying tax and national insurance, therefore expanding the tax free personal allowance by the level of contributions.

Personal pensions

In contrast, personal pension schemes are made after earnings have been taxed. Here the pension provider claims back the basic rate of tax at 20% from the government. So, every £80 paid into a personal pension scheme, results in a total of £100 in the pension kitty.

If you are a higher rate tax payer, the difference between the basic rate of tax at 20% and the higher rate at 40%, is an extra 20%, which is claimed via the self-assessment tax return. This is achieved by expanding the basic rate tax bracket by the level of contributions made.

Limit of reliefs

There is no limit on the contributions payable into pension schemes each year, however the tax relief that can be claimed does have a limit. This is calculated as the higher of the sum of total earnings in the tax year OR £3,600, which is the current minimum limit. Taking this a step further, there is also a Pension Annual Allowance which cannot be exceeded; it is currently set at 50,000 for 2013/14 although it is set to drop to 40,000 for the coming tax year, 2014/15.

Unused relief on pensions

These allowances can be carried forward for a period of three years. So an annual allowance of £50,000, provided no contributions have been made, could make available an allowance of £200,000 in a current period. Unused allowances not used in a required time frame are lost.

So as you can see there are some benefits that are worth understanding around pensions and the tax relief thereon. Even non tax payers can benefit, paying £2,880 into a pension and getting £3,600 in the pot.