Tax relief at source - worse off?

AmbitiousMan

Hi, I was of the impression that both tax relief at source and contribution at source should produce the same net impact. For example, contribution of £10K pension at source, from gross salary into an employers pension fund should have the same effect as contributing £6K on your own, into a private fund of your choice.

However, when I compare the two scenarios, the person making a contribution to the employers pension ends up being better off - even though a quick google search will tell me that both scenarios should have the same net effect.

I cant get my head around this. This thing is bothering me and I have tried to think of everything but cannot understand where I am going wrong. Surely, I must be wrong - HMRC cannot have got this wrong?

I would be most grateful if someone could look at the two scenarios below - explained with numbers - and then help me understand what I am missing.

For simplicity, I ignore any impact of national insurance contributions and the person is based in England.

Hypothetical Income of this person - £110,000, for 2024-25

Scenario1: Person lets the employer deduct £10,000 from gross salary (at source) - £10,000
In my view, this person ends with a total package of £82, 568 by the year end, as shown below:

Income after pension contribution: £100,000
Less: income tax: (£27,432)
Add: Pensions developed over the year :£10,000
Total = net income - taxes + pension benefit: £82,568

Scenario2: Instead of a salary sacrifice at source, this person makes pension contributions from their net take home salary, totalling to £6,000 for the year. However, now they end up £625 worse off as compared with Scenario 1 (despite being on 40%tax band) as their total benefits drops to £81,943

In this scenario, 

Their net income, for tax calculation (after a pension contribution of £6,000) is £104,000
Less: income tax on this income after adjusting for the base rate - the way HMRC does 
(£29,557)
[this has been calculated by increasing the 20% taxable income and reducing the 40% taxable income by £7500/.8]

Add: Pensions developed over the year: £7500 (£6000 + £1500 - topped up by pension provider)
Total = net income - taxes + pension benefit = £81,943 

So in Scenario 2, the person ends up worse off. Have I made a mistake in my calculations? How can we explain this?

Many thanks for looking.

NoMore

Of course they are different because your not comparing like for like. Your not contributing the same Gross amount into the pension in each scenario.

In scenario 2 you would contribute £8k and the Pension would claim basic Tax relief of £2k giving you a total in pension of 10k. You then claim the extra tax relief from the HMRC which means you should end up in the same position as scenario 1.

Dazed_and_C0nfused

AmbitiousMan said:

Hi, I was of the impression that both tax relief at source and contribution at source should produce the same net impact. For example, contribution of £10K pension at source, from gross salary into an employers pension fund should have the same effect as contributing £6K on your own, into a private fund of your choice.

However, when I compare the two scenarios, the person making a contribution to the employers pension ends up being better off - even though a quick google search will tell me that both scenarios should have the same net effect.

I cant get my head around this. This thing is bothering me and I have tried to think of everything but cannot understand where I am going wrong. Surely, I must be wrong - HMRC cannot have got this wrong?

I would be most grateful if someone could look at the two scenarios below - explained with numbers - and then help me understand what I am missing.

For simplicity, I ignore any impact of national insurance contributions and the person is based in England.

Hypothetical Income of this person - £110,000, for 2024-25

Scenario1: Person lets the employer deduct £10,000 from gross salary (at source) - £10,000
In my view, this person ends with a total package of £82, 568 by the year end, as shown below:

Income after pension contribution: £100,000
Less: income tax: (£27,432)
Add: Pensions developed over the year :£10,000
Total = net income - taxes + pension benefit: £82,568

Scenario2: Instead of a salary sacrifice at source, this person makes pension contributions from their net take home salary, totalling to £6,000 for the year. However, now they end up £625 worse off as compared with Scenario 1 (despite being on 40%tax band) as their total benefits drops to £81,943

In this scenario, 

Their net income, for tax calculation (after a pension contribution of £6,000) is £104,000
Less: income tax on this income after adjusting for the base rate - the way HMRC does 
(£29,557)
[this has been calculated by increasing the 20% taxable income and reducing the 40% taxable income by £7500/.8]

Add: Pensions developed over the year: £7500 (£6000 + £1500 - topped up by pension provider)
Total = net income - taxes + pension benefit = £81,943 

So in Scenario 2, the person ends up worse off. Have I made a mistake in my calculations? How can we explain this?

Many thanks for looking.

You have completely misunderstood how pensions tax relief works.

If you get £10,000 into your pension using the salary sacrifice method then you have £10,000 in your pension and £10,000 less taxable income then you would otherwise have had.  As you have £10,000 less taxable income your adjusted net income is also £10,000 less than it otherwise would be. 

You do not benefit from any pension tax relief though as this is an employer contribution 

If you contribute using the "relief at source" method then, the £6,000 will benefit from £1,500 in pension tax relief*, making a gross contribution of £7,500.  This £7,500 does not reduce your taxable income.  But it does increase your basic rate band by £7,500 and it also reduces your adjusted net income by £7,500.

*you can only ever get 20% pension tax relief (25% of your net contribution), if you are liable to tax above the basic rate then you will have a personal tax saving but this is never added to your pension fund so if you think a higher rate payer contributing £6,000 (net) ends up with £10,000 in their pension fund you are wrong.  If you want £10k in your pension fund you would have to hand over £8k to the pension company (using the RAS method)

DRS1

We have had this self same question before not long ago.  I can't help wondering why.

AmbitiousMan

Hello,

Thank you for your response - I am most grateful. I provided an illustrative example to show my point but I suspect it is too detailed for a first post, and I remove detail to highlight the issue first.

In Scenario 1 - this is an additional voluntary contribution made by employee only (no employers contribution here). They make £10,000 additional contributions; they get a tax relief of £4,000 at source; in essence, for each £1 cost, they get a 40p benefit (60p benefit per £1 cost).

In Scenario 2, if they invest £6,000 post tax, outside of their employers scheme (£6,000 is extrapolation of the 60p cost in Scenario 1). Now they are worse off. They pay £4,000 more in tax than Scenario 1; they spend £6,000 contributing to a pension scheme; they get tax relief from HMRC of £1,500 and a pension top up of £1,500. In essence, for every £1 cost (40p in additional tax and 60p post tax pension top up), they get a 30p benefit - 10p worse than Scenario 1.

So on a like for like basis, from a tax perspective, Scenario 1 becomes better than Scenario 2 - on a relative - pound per pound basis. This issue never comes up on a google search but if true, this should be an important factor for those who decide to make voluntary additional pension contributions.

I am surprised on discovering this because it provides an intrinsic benefit to the employers scheme, is anti competitive on that basis, and therefore, it feels unfair that individuals making additional voluntary contributions outside of their employers scheme are penalised by HMRC. 

I hope someone proves me wrong. I would better understand if an illustrative example of the two scenarios can be provided to prove me wrong...

Kind regards,


Dazed_and_C0nfused said:

AmbitiousMan said:

Hi, I was of the impression that both tax relief at source and contribution at source should produce the same net impact. For example, contribution of £10K pension at source, from gross salary into an employers pension fund should have the same effect as contributing £6K on your own, into a private fund of your choice.

However, when I compare the two scenarios, the person making a contribution to the employers pension ends up being better off - even though a quick google search will tell me that both scenarios should have the same net effect.

I cant get my head around this. This thing is bothering me and I have tried to think of everything but cannot understand where I am going wrong. Surely, I must be wrong - HMRC cannot have got this wrong?

I would be most grateful if someone could look at the two scenarios below - explained with numbers - and then help me understand what I am missing.

For simplicity, I ignore any impact of national insurance contributions and the person is based in England.

Hypothetical Income of this person - £110,000, for 2024-25

Scenario1: Person lets the employer deduct £10,000 from gross salary (at source) - £10,000
In my view, this person ends with a total package of £82, 568 by the year end, as shown below:

Income after pension contribution: £100,000
Less: income tax: (£27,432)
Add: Pensions developed over the year :£10,000
Total = net income - taxes + pension benefit: £82,568

Scenario2: Instead of a salary sacrifice at source, this person makes pension contributions from their net take home salary, totalling to £6,000 for the year. However, now they end up £625 worse off as compared with Scenario 1 (despite being on 40%tax band) as their total benefits drops to £81,943

In this scenario, 

Their net income, for tax calculation (after a pension contribution of £6,000) is £104,000
Less: income tax on this income after adjusting for the base rate - the way HMRC does 
(£29,557)
[this has been calculated by increasing the 20% taxable income and reducing the 40% taxable income by £7500/.8]

Add: Pensions developed over the year: £7500 (£6000 + £1500 - topped up by pension provider)
Total = net income - taxes + pension benefit = £81,943 

So in Scenario 2, the person ends up worse off. Have I made a mistake in my calculations? How can we explain this?

Many thanks for looking.

You have completely misunderstood how pensions tax relief works.

If you get £10,000 into your pension using the salary sacrifice method then you have £10,000 in your pension and £10,000 less taxable income then you would otherwise have had.  As you have £10,000 less taxable income your adjusted net income is also £10,000 less than it otherwise would be. 

You do not benefit from any pension tax relief though as this is an employer contribution 

If you contribute using the "relief at source" method then, the £6,000 will benefit from £1,500 in pension tax relief*, making a gross contribution of £7,500.  This £7,500 does not reduce your taxable income.  But it does increase your basic rate band by £7,500 and it also reduces your adjusted net income by £7,500.

*you can only ever get 20% pension tax relief (25% of your net contribution), if you are liable to tax above the basic rate then you will have a personal tax saving but this is never added to your pension fund so if you think a higher rate payer contributing £6,000 (net) ends up with £10,000 in their pension fund you are wrong.  If you want £10k in your pension fund you would have to hand over £8k to the pension company (using the RAS method)

Dazed_and_C0nfused

You are comparing apples and pears.

Scenario 1 involves a £10,000 pension contribution.

Scenario 2 involves a £7,500 contribution.

QrizB

AmbitiousMan said:

In Scenario 1 - this is an additional voluntary contribution made by employee only (no employers contribution here). They make £10,000 additional contributions; they get a tax relief of £4,000 at source; in essence, for each £1 cost, they get a 40p benefit (60p benefit per £1 cost).

In Scenario 1, your hypothetical man is £6000 worse off and has gained a £10000 pension contribution.

AmbitiousMan said:

In Scenario 2, if they invest £6,000 post tax, outside of their employers scheme (£6,000 is extrapolation of the 60p cost in Scenario 1). Now they are worse off.

No. Or rather, yes but this is not directly comparable to Scenario 1.

they spend £6,000 contributing to a pension scheme

They spend £4500 (£6000-£1500) to get a £7500 contribution to a RAS pension scheme. In Scenario 1 they spent £6000 to make a £10000 contribution. In Scenario 2 they have spent less and therefore have a smaller pension contribution as a result.

If they wanted to make a £10000 gross contribution to a RAS pension scheme:

• Contribute £8000 net
• Receive £2000 tax relief, to get the £10000 contribution
• Receive another £2000 of benefit from now having £10000 of income taxed at 20% not 40%

Overall result, they have spent £6000 (£8000-£2000) to get a £10000 pension contribution.

I hope someone proves me wrong. I would better understand if an illustrative example of the two scenarios can be provided to prove me wrong...

Three of us have now proved you wrong.

400ixl

There is also an NI cost as well in scenario 2 as well isn't there?

QrizB

400ixl said:

There is also an NI cost as well in scenario 2 as well isn't there?

There could be NI costs in both, depending on whether Scenario 1 is net pay or salsac? We've all ignored those so far.

AmbitiousMan

Sorry for persisting on this. I will post an excel table shortly comparing like for like, apples and apples scenario and open it to critique!

AmbitiousMan

I produced an excel table, and it shows that this hypothetical person ends up in the same position in both scenarios. I also added another scenario (a made up one) when pension provider somehow gives a 40 percent top up to this person.

I provide that below in case someone else is also going around in their head and finds a numerical illustration useful. 

 

 thanks all for debating with me! 

I needed to settle this in my head