When it comes to tax efficiency, the pension is just about as good as it gets.
Advancements in medical science mean that we are all living longer, and make it an inevitability that we will live longer still in the future. This is, of course, a good thing.
However it does place a greater and greater financial burden on the state to support people into their old age. In order to try and encourage individuals themselves to bear more of this burden, current rules make saving into pensions blisteringly attractive - particularly for higher and additional rate tax payers:
Not only do pension contributions benefit from tax relief at your marginal rate (free money x 1), but your employer may agree to match any contributions that you make (free money x 2);
Any growth that is generated within your pension is tax-free;
When you reach the age that you can make a withdrawal from your pension (for the vast majority of people reading this, this will be 57 at least), you can withdraw up to a quarter of the total value of your pension at that stage free of tax; and
Assets that sit within a pension currently sit outside of your estate, and are therefore not subject to inheritance tax.
Free money on the way in, tax free on the way through and tax efficient on the way out. “My property is my pension” - nope, sorry, not even close.
If you can afford to tie the money up for 10/20/30 years (delete as appropriate) then lobbing some money into a pension is, at worst, a very sensible thing to do. At best, it’s a no brainer.
Assuming that you are sold on the idea, the question then becomes “well, how do I make a pension contribution?”. This will be our topic of focus today.
It can get a bit technical, but stick with me because the numbers are extremely compelling for most people.
There are, broadly speaking, two methods of getting money into your pension.
Making a Pension Contribution through PAYE (Pay As You Earn)
In this scenario, the money goes straight from your employer into your pension. Your employer deducts your pension contribution from your salary automatically before paying whatever tax that is due on your earnings to HMRC. Pension contributions made through this method are listed on your payslip each month.
This set up is known as a “net pay arrangement” - but you don’t need to know that because you have a life.
The PAYE route is simpler for you as you don’t need to do anything further to ensure that you are credited with the appropriate tax relief. This is because the money is never paid to you personally - it goes straight into your pension, so it is never taxed.
By law, under the auto enrolment rules, your employer is required to put a minimum of 3% of your salary into your pension each month*. Many employers choose to contribute more, but the key point here is that almost all of us are making and receiving contributions into our pension each month through this kind of arrangement. In many cases, without even realising it.
There are other potential benefits of the PAYE method. As I mentioned above, your employer might match whatever contributions you choose to make personally, up to a limit.
If you want to increase the amount that you are putting into your pension through this method, you should speak to your HR department. But just be mindful of the annual limit on what you can put into your pension (which is currently the lower value of either a) your total salary, including bonuses, or b) £60,000)**.
Overall the main advantage of the PAYE method is simplicity, and we are big fans of that here.
Final point as an aside, those of you who own your own business can arrange to make an employer pension contribution straight from your business cash account into your pension. This can be an extremely tax efficient method of getting money out of the business, but it is worth speaking with your accountant/financial adviser first to get a second pair of eyes on the sums.
Making a Personal Pension Contribution
If you’re self-employed or want to put money into a pension that is separate from your employer’s pension scheme, then you can make a personal pension contribution.
This means that you pay into a pension scheme yourself from your personal bank account. This route is less simple, as there will be more for you to do - but broadly speaking the mechanics work like this:
If you are a basic rate taxpayer, once you have paid the money into your pension, your pension provider will claim the appropriate tax relief for your automatically. This is referred to as a “relief at source” arrangement. There is nothing more for you to do.
If you are a higher or additional rate taxpayer, once the money has been paid into your pension, your pension provider will claim back the basic rate tax relief only. It is on you, or your accountant, to claim back the additional tax relief that you are due through your self assessment tax return.
If you don’t remember to proactively claim the additional tax relief you will be missing out on a chunk of change, which is never great…
Poor Mollie.
None of the above constitutes tax advice, if in doubt speak with a qualified tax adviser.
*In this scenario, if your employer is contributing 3% of your salary to a pension you will automatically be contributing a minimum of 5% (including tax relief) yourself, so that a minimum of 8% in total is going in each month. You can opt out of this arrangement, but in almost every conceivable scenario this isn’t a good idea.
**If you earn more than £60,000 this tax year, and have the cash available to put more than £60,000 into your pension, then you might be able to use some unused allowance from previous tax years. Again, this can get complicated so worth speaking with an adviser to confirm.
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