Meg Saksida explains the mechanics and benefits of contributing to an occupational pension scheme.
Pension savings
Most individuals in the UK will be eligible for the state pension. This is a monthly amount payable to the individual once they reach pensionable age (currently 66 in the UK), at a level depending on the level of the National Insurance payments that the individual has paid over their working life. At under £10,000 a year (£179.60 a week for 2021-22), taxpayers often wish to top up the state pension and to do this with either or both a private personal pension, or a pension connected to their employment, called an occupational pension scheme.
Since 2012 a program of ‘auto enrolment’ was rolled out by the government, such that by now, all employers must offer an occupational pension scheme to their employees and contribute a minimum amount to it.
Advantages of a pension
There are several advantages of contributing to an HMRC registered pension scheme rather than saving the money personally to top up the state pension. The main one of these advantages is tax. The first advantage is that when amounts are input into the employer’s occupational pension scheme by both the employee and employer, the earnings are free of income tax. Further to this, when the amounts invested by the pension fund manager earn interest or dividends, there is no tax on the investment income, so pension funds grow tax-free. Finally, where the pension scheme reorganises investments in their portfolio, any gains on the disposals will be free of capital gains tax.
How much can an individual contribute to their pensions every year?
The point of the pension benefits outlined above is to encourage employees to save whilst they are working, in preparation for a time when they are not working. Therefore, the idea is for the employee to use their earnings to contribute to their pension pot, not their savings or their income from investments or other reserves. The maximum amount a taxpayer can contribute is the higher of either their earnings or £3,600 a year. So if an individual does not have earnings, the maximum they can contribute is £3,600, but if they have earnings of, say, £300,000, they can contribute up to £300,000. This restriction is not applied to the employer contributions, so they can contribute more than £3,600 even if the individual does not earn above that level.
How much tax relief can individuals get?
Although taxpayers can contribute up to the limit of their earnings, they can only get tax relief on £40,000 a year (the annual allowance (AA)). If they were a member of a registered pension scheme in the three previous years, they could use any capacity they might have in those years if they had not contributed the full AA available (on a FIFO basis). There are further restrictions on the contribution amount available for high earners, but the allowance never goes under £4,000. Any contributions over the individuals available AA attracts income tax at the taxpayer’s marginal rate.
How is the relief obtained?
Relief for occupational pension schemes is given as ‘net pay arrangements’. This means that employees are taxed on their net earnings after the pension contribution amounts have been taken off. This flows through to their remaining earnings such that they automatically obtain the tax relief at their marginal rate. Any amounts contributed by their employer will also be tax-free. These employer contributions are deductible expenses for the employer company.
Practical tips
Contributing to a pension scheme is a highly tax-efficient way of saving for the future. The earlier an employee starts, the longer the capital savings have to accumulate tax-free.
