Pension contributions: What a relief!

Joe Brough outlines the tax relief available when making pension contributions. 

Making pension contributions is a tax-efficient way of saving for retirement. The planning and timing of pension contributions can also contribute to a tax-efficient remuneration strategy for owner-managed businesses.  

When UK individuals aged under 75 who are members of a relevant pension scheme make personal pension contributions, tax relief is available on their gross contributions in a tax year, up to the higher of their ‘relevant UK earnings’ and £3,600 (£2,880 net).  

‘Relevant UK earnings’ for pension contribution purposes include: 

• employment income; 

• income from a trade or profession; and 

• furnished holiday lettings profits from the UK or EU. 

Importantly, investment income does not count towards ‘relevant UK earnings’. Therefore, income from dividends for shareholders will not count towards the annual earnings threshold. 

For tax deductibility purposes, pension contributions made by an employer are subject to the ‘wholly and exclusively’ rules which govern all expenses. Where the pension contribution is made on behalf of a company director shareholder, HMRC generally takes the view that the contribution is made ‘wholly and exclusively’ for trade purposes. 

Annual maximum 

In addition to the restriction on tax relief for relevant UK earnings in a tax year, HMRC also applies an overall maximum annual allowance to individuals for whom contributions to their pension pots can receive tax relief. For the tax year 2023/24, the maximum annual allowance is £60,000. Prior to the start of 2023/24, the limit was £40,000 per year.  

For a ‘defined contribution’ scheme, the £60,000 maximum applies to all contributions paid into the scheme by both an individual and their employer. For a ‘defined benefit’ scheme, the £60,000 maximum is compared against the total pension growth for the year. 

Where an individual has been a member of a qualifying pension scheme within the previous three tax years and has not used their full annual allowance in each year, any unused allowance can be carried forward for a maximum of three tax years. When allocating pension contributions against the annual allowance, the current year’s allowance is used first, followed by the oldest tax year on a first-in, first-out basis. 

Where the annual maximum allowance is exceeded, this will result in a personal income tax charge on the individual at their marginal tax rate. Whilst this is a personal income tax liability, in certain circumstances an election can be made for the pension fund to pay the excess tax charge. However, before doing so, the taxpayer should consult their financial adviser as to the effect this may have on their pension pot going forward. 

The annual maximum is also subject to tapering for individuals with threshold income exceeding £200,000 and adjusted net income exceeding £260,000. Where these thresholds are both exceeded, the annual allowance of £60,000 is reduced by £1 for every £2 that the adjusted threshold is exceeded, subject to a minimum allowance of £10,000.  

Where a member of a pension scheme has flexibly accessed their pension benefits, the annual maximum is subject to the ‘money purchase annual allowance’ (MPAA) of £10,000. 

Company contributions 

For limited companies, employer pension contributions made on behalf of directors are generally tax-deductible when calculating profits chargeable to corporation tax. Employer pension contributions are also an exempt benefit-in-kind for the individual concerned.  

The rate of corporation tax applicable to company profits is dependent on the total profits made in the chargeable accounting period. Assuming that there are no ‘associated’ companies, and the accounting period is for twelve months, profits under £50,000 are taxed at 19%, with profits exceeding £250,000 taxed at 25%. For profits between £50,000 and £250,000, profits are taxed at 25% less marginal relief. The effective marginal rate of corporation tax for profits falling within the marginal rate band is 26.5%. Therefore, a company making pension contributions on behalf of an owner-manager can receive significant corporation tax savings. 

Corporation tax relief on employer contributions by companies is not limited to the ‘relevant UK earnings’ of the owner-director. However, when planning pension contributions, consideration must be given to the individual's available annual allowance. Without careful planning, it is possible for a company pension contribution to result in the individual exceeding their annual allowance and thus incurring a personal tax charge on the excess. 

For the pension contribution to be deductible when calculating taxable profits, the business must ensure that the contribution is paid before the end of the chargeable accounting period. Any pension contributions accrued for but not paid will not be relievable until settled by the company in cash. 

Unincorporated business 

Pension contributions for the proprietor or partner of an unincorporated business are not a tax-deductible expense for the business in the same way as a limited company. Contributions paid into schemes for the owner of an unincorporated business are not allowable deductions when calculating taxable profits.  

For payments into personal pension schemes, unless the scheme is a retirement annuity contract, basic rate tax relief will be claimed back by the pension administrator, with the contribution by the individual being made net of basic-rate tax.  

Higher and additional rate tax relief will be obtained by extending the basic rate band of the individual by an amount equal to the net contribution made, grossed up for basic rate tax. Therefore, a sole trader with taxable profits of £80,000 who pays £8,000 net into their pension scheme will receive a £2,000 tax reduction on their income tax liability. The pension scheme will receive a gross contribution of £10,000 for an overall net contribution of £6,000 by the taxpayer. 

Spreading of tax relief for the employer 

In most cases, an employer’s pension contribution will be fully deductible in the year in which it is paid. However, where there is a substantial increase in contributions in successive periods, any excess contributions will be subject to spreading over a period of two to four years, depending on how large the excess is. 

Contributions are subject to spreading when the contributions paid in the current period exceed 210% of the amount paid in the previous period and the amount of the excess is more than £500,000. 

The excess amount is calculated as the amount by which the increase in contributions exceeds 110% of the prior period’s contributions. 

In the first period during which an employer starts to make pension contributions, spreading will not apply, even if contributions exceed £500,000. Contributions which represent cost of living increases for pension members or benefits for future service for members joining the scheme in the current period, can be excluded when calculating spreading adjustments. 

Other benefits of pension contributions 

When made in an individual capacity, pension contributions will result in a reduction of the taxpayer’s ‘adjusted net income’ for a tax year. This can be useful tax planning whether the individual is a director of a company or a proprietor in an unincorporated business. 

Adjusted net income is the measure used when considering whether an individual has exceeded both the £50,000 threshold for the clawback of child benefit claims, and the £100,000 threshold after which the personal allowance begins to be tapered by £1 for every £2 that the £100,000 threshold is exceeded. 

In both cases, the gross pension contribution will reduce the individual's adjusted net income by the value of the contribution, grossed up by basic rate tax relief. Any contributions paid by a limited company on behalf of a director shareholder will not reduce their adjusted net income. 

Practical tip 

Making pension contributions can be a tax-efficient way of extracting funds from the business, reducing taxable profits and reducing personal tax liabilities. However, without careful planning contributions can also result in personal tax liabilities for individuals.