Recent uncertainty shines a light on the extraordinary benefit of pension tax relief

Since 23 September I have looked at the impact of additional rate tax being cut, how carry forward could be used to maximise tax relief before the axe, considered the impact of having relief at source paid at a different rate to basic rate tax actually paid for a year, looked at the winners and losers under net pay, and contemplated all the scenarios north of the border if Scottish tax stayed constant when rest of the UK changed.

Despite all the speculation, policy pledges, U-turns (and U-turns on U-turns) of the past few months, we are essentially back where we started again.

While all the uncertainty has been frustrating, it shines a light on the extraordinary benefit of pension tax relief, making it a good time to reflect with clients on the big appeal of pensions:

Tax relief

The underlining concept of tax relief on personal pension contributions is that you get back the tax you have paid. So, whatever the rate of tax you pay it will cost you the same amount to get it into your pension.

If you have £1,000 gross income that you pay 20 per cent tax on, you get £800 and put it into your pension, and you get £200 tax relief to end up with £1,000 in your pension.

If you pay 19 per cent tax you get £810, pay it into your pension and you end up with £1,000 in your pension too – you are no better or worse off.

Someone paying 45 per cent tax puts the same £800 in with 20 per cent relief at source to have £1,000 in the pension, but they get back £250 from HMRC, so the net cost is £550.

If relief at source was 19 per cent they pay in £810 initially but get back £260 so end up in the same position. Key point here is pension contributions make sense for tax relief purposes whatever the rate.

Salary sacrifice

Of course, it is not just income tax that has been the subject of political tinkering. We have also seen changes to national insurance and the proposed introduction, followed by scrapping, of the health and social care levy.

It is a timely reminder of the benefits of sacrificing salary in favour of employer contributions, rather than making personal pension contributions. Both employer and employee save on the NI. The recent headlines concerning NI rates can be a useful prompt for discussions with those not already using salary sacrifice.

Net pay

Net pay schemes work well for higher earners, and in Scotland that will include anyone paying the 21 per cent intermediate rate of income tax, not just higher and additional-rate taxpayers.

Under net pay, full tax relief is granted automatically, without the need to complete a self-assessment or contact HM Revenue & Customs.

However, it fails anyone earning below the personal allowance as they miss out on the 20 per cent tax relief they would get if they were paying into a relief at source scheme. After years of these people losing out, plans have finally been put in place in an attempt to resolve this.

However, the first claims cannot be made until 2025-26 relating to the 2024-25 tax year. It also looks like lower-paid employees will have to take action to claim the extra tax relief, unlike under relief at source schemes where it happens automatically.

This of course means there are likely to be many who do not bother, or are not aware of what they need to do, especially when you consider these are likely to be some of the least engaged pension savers.

Ideally the net pay remedy would be a more automated system and brought in earlier, because it is those that need help the very most that are losing out, not just on the tax relief itself but also on the compounding effect, which we know is so very valuable.

Lisa Webster is senior technical consultant at  AJ Bell