Running a pension scheme
Tax advantages of pension schemes
Pension schemes registered with HM Revenue & Customs (HMRC) enjoy significant tax advantages.
Within limits, contributions from employees to HMRC-registered pension schemes are effectively deducted from income before tax. Sometimes tax relief is given at source. With other schemes it has to be reclaimed by either the pension provider or the employee. If a taxpayer is on the basic rate of 20 per cent and they pay £100 into a pension scheme, it will cost them £80 after tax relief is given.
Higher-rate taxpayers benefit even more. Income and capital gains generated within the pension fund also qualify for tax relief.
Pension savings and tax
Tax rules on pension savings were simplified. There is now no limit on the amount that may be contributed to a registered pension scheme, though individual pension schemes may set their own limits. However, there is an annual limit on the amount of tax relief that can be given on contributions and other increases in a person's pension rights. There is also an overall ceiling on the amount of pension provision that may accumulate with the benefit of tax relief. Some of the main changes are listed below.
- There is a 'lifetime allowance', which limits the total amount of pension savings that an individual may accumulate with the benefit of tax relief. It takes account of stock market performance and increases in defined benefit accruals as well as contributions. The lifetime allowance is £1.07 million for 2020-21.
- There is also an 'annual allowance' which limits the annual tax relief which an individual may receive on pension contributions and other increases in a person's pension rights. More can be contributed but the tax exemption on the excess will be recovered. The annual allowance is £40,000 for 2020-21. Individuals who have been a member of a registered pension scheme and who have unused annual allowance from the previous three tax years can carry that allowance forward, meaning they may not have to pay the annual allowance charge.
- In some schemes, tax relief can be given on contributions up to £4,000 a year without reference to your level of income. Amounts above this will attract tax relief provided total pension contributions do not exceed 100 per cent of the individual's earnings, though tax relief on contributions over the annual allowance will be recovered.
Although pensions are taxed as income, there is another tax break when taking benefits for people who have built up a pension fund under a registered pension scheme. Up to 25 per cent of the value of the fund - providing the aggregate of such lump sums does not exceed one quarter of the lifetime allowance - can be taken as a tax-free lump sum.
Employers also get tax breaks from registered pension schemes, because costs - including contributions and expenses - can usually be set off against corporation tax.