How to calculate tax relief when buying additional pension in a defined-benefit scheme?

SouthLondonUser · 8 December 2019 at 11:26AM

If you contribute to a DC-scheme, the value of your contribution is, banally, the amount you paid into the scheme; tax relief is capped at £40k per year (for most people - going down to £10k for the very high earners).

If you contribute to a DB-scheme, I understand that HMRC calculates the value of your contributions, for the purposes of tax relief, by multiplying by 16 the amount by which your entitlement has gone up in the tax year. So, if it has gone up by £3,000 , to HMRC that's worth £48k, so there's an extra £8k on which you don't get tax relief but must pay taxes.

Is all of this correct?

What I struggle to understand is how the calculations work when HMRC's value is different from the actual cost to you.
Let's consider the case of buying additional pension, e.g. with a one-off lump-sum payment.

Let's say that you buy £1,000 of additional pension and that, based on your age etc, this costs you £10k. But HMRC values that contribution at £16k. So you get tax relief on... what? The minimum between £10k and £16k? On £16k even if it didn't cost you £16k?

How does it work? I am confused and haven't been able to find a clear explanation.

Any clarification would be most welcome! Thanks!

NedS · 8 December 2019 at 12:44PM

You get tax relief on what it costs you, so in your example you would get tax relief on the £10K cost to you. The £16K figure (£1K x 16) is the value you use when calculating how much of your £40K annual allowance you have used up, so for example, you could contribute a further £24K gross (£19,200 net) into a SIPP and stay within your £40K annual allowance (assuming you have relevant earnings of £40K or more)

SouthLondonUser · 8 December 2019 at 6:06PM

I see. Can you please help me understand if I got this right, then? Assuming you have more than £40k of earnings but less than the £150k after which the £40k start to get reduced:

If buying £1 of additional pension costs you £10, then the maximum additional pension you can buy in one year, and still get tax relief on, is £2,500 ( = £ 40k / 16, where 16 is HMRC's rule), even if it costs you £25k and not £40k.

If instead buying £1 costs you, say, £20, then the maximum you can buy in your DB pension in one year is £2,000, which would cost you £40k. However, since HMRC "values" this contribution at £32k, you can still contribute £8k in a defined contribution scheme.

Is all of this right?
Most of all, is this explained anywhere on the HMRC or gov UK website? I couldn't find it.

Also, if your earnings are £50k, in theory you can contribute up to £40k, but, in reality, you only get tax relief on £37.5k ( = £50k - £12.5k) because the first £12.5k of income are tax-free, so there is no tax to claim back. Right?

hugheskevi · 8 December 2019 at 7:00PM

Assuming you have more than £40k of earnings but less than the £150k after which the £40k start to get reduced:

The taper starts at £150,000 of Adjusted Income, which includes pension input, so will apply at a much lower level than £150,000 of earnings.

If buying £1 of additional pension costs you £10, then the maximum additional pension you can buy in one year, and still get tax relief on, is £2,500 ( = £ 40k / 16, where 16 is HMRC's rule), even if it costs you £25k and not £40k.

There would also be the pension input from the main-scheme pension to take into account in the calculation, as well as carry-forward of unused Annual Allowance from the last 3 years to factor in.

If instead buying £1 costs you, say, £20, then the maximum you can buy in your DB pension in one year is £2,000, which would cost you £40k. However, since HMRC "values" this contribution at £32k, you can still contribute £8k in a defined contribution scheme.

No, you can buy as much or as little as you like, subject to scheme-imposed limits on total amount which can be purchased.

In this example, you could purchase £2,500 of Added Pension at a cost of £50,000 and receive tax relief on £50,000 (subject to adequate earnings). This would have a pension input of £40,000 for Annual Allowance purposes.

Most of all, is this explained anywhere on the HMRC or gov UK website? I couldn't find it.

The Pension Tax Manual is the best source of information, but it isn't an easy read.

Also, if your earnings are £50k, in theory you can contribute up to £40k, but, in reality, you only get tax relief on £37.5k ( = £50k - £12.5k) because the first £12.5k of income are tax-free, so there is no tax to claim back. Right?

Correct (for Added Pension purchases).

Dazed_and_confused · 8 December 2019 at 8:13PM

A lot of contributions to a DC scheme are paid under the "relief at source" rules so your individual tax position strictly has no bearing on the tax relief added by the pension company.

So you could in theory have total taxable earnings of £50,000 and if they were all relevant for pension contribution purposes (and have sufficient carry forward available) you could contribute £40,000 and the pension company, courtesy of HMRC, would add 25% giving you £50,000 in the pension fund even though you have only been taxed, after deducting the Personal Allowance, on £37,500.

A relief at source contribution doesn't reduce your taxable income so unless you are Scottish resident for tax purposes this would not save you any personal income tax whatsoever. But you do have an immediate increase of £10,000 on your contribution.

SouthLondonUser · 8 December 2019 at 11:22PM

@dazed, when you say 'relief at source' do you mean 'salary sacrifice'?

I am not sure I follow what you mean; salary sacrifice does reduce taxable income; the main difference between contributing to a DC via salary sacrifice rather than by paying out of your post-tax income is that salary sacrifice saves you national insurance, too, but that's a separate point from how to calculate how much one can contribute into a defined-benefit scheme.

SouthLondonUser · 8 December 2019 at 11:35PM

hugheskevi wrote: »

There would also be the pension input from the main-scheme pension to take into account in the calculation, as well as carry-forward of unused Annual Allowance from the last 3 years to factor in.

Let's see if I got this right:

Let's say that, for the last 3 years, the gross income was £40k but the taxable income reported in the P60 was £35k, because of all the salary sacrifice contributions, and that each year you acquired £1,000 worth of pension, revalued every year as per the rules of the scheme.

HMRC "values" (I'm sure there's a more precise term...) those contributions at £16k, so there is still £24k worth of unused allowance every year.
These £24k correspond to £1,500 of additional pension every year.

So, carrying over the unused allowance of the last 3 years means that this year you can buy £1,500 x 3 = £ 4,500 of additional pension, which would cost you (in my first example) £45k.

You don't have £45k of income this year, but, since this is to do with your unused allowance of the last 3 years, you still get the basic 20% tax relief.

Is this correct ? Is this how it would work?

Thanks!

BTW, this is not for me - someone else has asked me for help but I am not too familiar with DB schemes. Given the sums involved (the person is considering investing a decent lump sum), I think he should consult (and pay for) a tax accountant or some kind of financial advisor, to make sure the tax relief works as thought, but these answers are very useful in providing much needed clarity and in framing what to ask the advisor - thanks a lot!

Dazed_and_confused · 8 December 2019 at 11:36PM

@dazed, when you say 'relief at source' do you mean 'salary sacrifice'?

No, salary sacrifice contributions don't attract any pension tax relief whatsoever for the employee.

That is because the employee doesn't pay anything into the pension. They agree to a reduced salary and in return the employer makes a contribution to the pension. There is no pension tax relief due on employer contributions.

The employee benefits because they have a reduced salary and therefore pay less tax and National Insurance. For example salary might be £60k and they sacrifice £10k so their actual taxable salary is only £50k. So they have no tax or National Insurance to pay on the £10k sacrificed.

Relief at source payments are where the pension company, courtesy of HMRC, add basic rate tax relief to your contribution.

That type of pension contribution does not reduce your taxable income. But does increase the amount of your basic rate tax band.

It also reduces your "adjusted net income" which is used in calculating your Personal Allowance, the High Income Child Benefit Charge and, for the elderly, Married Couple's Allowance.

SouthLondonUser · 8 December 2019 at 11:48PM

Dazed_and_confused wrote: »

No, salary sacrifice contributions don't attract any pension tax relief whatsoever for the employee.

Salary sacrifice contributions attract tax relief in the sense that HMRC considers that the money was never part of the employee's income, but went straight into the pension pot before being taxed. The relief is automatic, and doesn't need to be claimed via a self-assessment if you are a higher earner.

I guess we were saying the same thing!

Dazed_and_confused wrote: »

Relief at source payments are where the pension company, courtesy of HMRC, add basic rate tax relief to your contribution.

Ah, what you mean is when you pay £8 into a DC pension, and HMRC automatically adds £2?
If instead you are in the 40% tax band, you are entitled to more tax relief but must file a self-assessment for that. In other words, only the tax relief for the 20% tax band is automatic - if you are in a higher band you must claim it via self-assessment.

That type of pension contribution does not reduce your taxable income. But does increase the amount of your basic rate tax band.

hugheskevi · 9 December 2019 at 12:21AM

You don't have £45k of income this year, but, since this is to do with your unused allowance of the last 3 years, you still get the basic 20% tax relief.

Is this correct ? Is this how it would work?

Everything prior to the above quote was fine.

Tax relief only applies to the current tax year. So you could only get tax relief on earnings - £12,500 on the Additional Pension purchase. You only carry-forward unused Annual Allowance for the purposes of assessing whether an Annual Allowance charge is due, not for tax relief.

Dazed_and_confused · 9 December 2019 at 1:29AM

If instead you are in the 40% tax band, you are entitled to more tax relief but must file a self-assessment for that. In other words, only the tax relief for the 20% tax band is automatic - if you are in a higher band you must claim it via self-assessment.

If you want any higher rate relief (or intermediate rate relief) on a relief at source contribution then you do need to let HMRC know however it isn't always necessary to file a Self Assessment return just for this reason.

If a return isn't needed for any other reason then it isn't usually needed just for relief at source pension contributions. Any additional tax relief could be allowed through an adjustment to the tax code (of the tax year the contribution was made in) and/or by a P800 calculation (the PAYE equivalent of the Self Assessment SA302) once the tax year has ended.

How to calculate tax relief when buying additional pension in a defined-benefit scheme?

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