What does tax relief really mean? Explaining the pension superpower you need to know about

Less than a third of us understand how our pensions are topped up by the tax system.

Research by Hargreaves Lansdown found that fewer than a third, just 31 per cent, of people could identify the purpose of pension tax relief.

“Pension tax relief is a major incentive to get people saving for retirement and yet the majority of people don’t know what it is,” says Helen Morrissey, head of retirement analysis at Hargreaves Lansdown.

“We need to raise awareness of this hidden hero of pensions to help people make the most of their retirement saving and save them from any nasty surprises.”

When you pay money into your pension, some of the income tax that would otherwise have gone to the Treasury is redirected into your pension instead.

For a basic-rate taxpayer, earning £100 normally means £20 going in income tax and £80 lands in your bank account. If you put that £80 into your pension, the Treasury adds the missing £20, taking the total contribution back up to £100.

The effect is that your pension gets a boost before the money is even invested.

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“I think it’s possibly the word ‘relief’ causing the understanding issue – it’s quite vague,” says Becky O’Connor, director of public affairs for PensionBee, suggesting something more specific like “tax-free pension contribution” would be clearer.

“Whatever it’s called, it’s vital to grasp it because if you don’t, you can’t truly understand the magic of pensions and why they are so brilliant for long term saving.”

How much income tax you pay affects how much money you get back from the Government when you contribute to your pension.

Basic-rate taxpayers pay 20% income tax, so to add £100 to their pension they need to pay in £80 with the government adding the remaining £20.

Higher-rate taxpayers pay 40% income tax, so a £100 pension contribution costs them £60, with the government adding £40.

Additional rate taxpayers pay 45% income tax, meaning a £100 contribution costs them £55, with £45 coming from the government.

There is a limit on how much of this tax top-up you can receive each year.

Pension contributions qualify up to an annual allowance of £60,000, or 100 per cent of your earnings if you earn less than that. Very high earners may also face a lower allowance.

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“You can even use a process called ‘carry forward’ to boost your contribution by making use of any unused annual allowances from the previous three tax years,” says Morrissey.

“It’s an enormously tax efficient way to make the most of your long-term saving.”

Additionally, you can benefit from this system even if you aren’t earning or paying income tax.

If you have a Self-Invested Personal Pension (SIPP) you can still pay in up to £2,880 a year and the government will top it up to £3,600.

“Parents and grandparents can help give their children and grandchildren a pension head start by saving on their behalf,” says James Scott-Hopkins, founder of financial planning firm EXE Capital Management.

Children can have SIPPs, and the government will add up to £720 a year too. If an adult pays in £2,880 a year every year from birth until 18, they will give the child £64,800 but with tax relief the government would have added a further £12,960.

One of the key things higher and additional rate taxpayers need to understand is that the extra tax refunds they are entitled to is not always applied automatically.

Basic rate income tax is usually added to your pension without you having to do anything. Pay in £80 and £20 will appear in your account from HMRC.

However, higher and additional rate taxpayers usually need to take action to receive the extra tax back they are due, often via a tax return.

Because people don’t understand how the system works “it routinely goes unclaimed,” says Antonia Medlicott, the founder of Investing Insiders.

There are exceptions, though. If your pension contributions are taken from your salary before tax is calculated the full tax refund is applied automatically.

With the tax return deadline looming at the end of January, higher and additional rate taxpayers should check how the extra tax refunds are applied to their pensions.

“If you do not claim it, it does not arrive later by magic. It is simply lost,” says Medlicott.

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