Pensions rules explained

15 May 2020

Find out everything you need to know with our Q&A guide.

How does tax relief on pension contributions work?

Are there any other tax benefits to saving in a pension?

How much can I pay into a pension?

What happens to my pensions when I retire?

Q) How does tax relief on pension contributions work?
A) To encourage people to save for their retirement, the government will pay tax relief on money you pay into a pension. This is equivalent to the level of income tax you pay and effectively means you make your contributions from pre-taxed income.

So, if a basic-rate taxpayer pays in £80, the government will top-up that contribution to £100 thanks to tax relief at 20%. A higher rate taxpayer gets tax relief at 40% so would only have to pay £60 to invest £100, while an additional rate taxpayer with tax relief at 45% would pay just £55.

If you are a member of a workplace scheme your employer will deduct your pension contributions from your salary before tax has been paid, meaning you only pay tax on the remainder. This means you get the full benefit of tax relief at whatever rate of income tax you pay and need to take no further action.

The situation is different for personal pensions as your contributions will be paid from your own taxed income. As a result your pension provider will claim 20% tax relief back from the taxman on your behalf. Higher rate taxpayers can claim a further 20% back, either through their tax return or by writing to or phoning HMRC. Additional rate taxpayers can claim a further 25% but this does need to be done through a tax return.

Q) Are there any other tax benefits to saving in a pension?
A) Yes. On top of tax relief on contributions, money saved in a pension accrues tax-free. When you retire you can take up to 25% of your fund as a tax-free cash lump sum to spend or invest as you choose.

You will have to pay income tax on the income the remainder generates, unless of course it does not exceed your personal allowance. In 2020/21, the personal allowance is £12,500. If you die before the age of 75 your pension can be passed on to the beneficiary of your choice tax free. If you die after age 75 it will only be subject to income tax at the recipient's marginal rate. Pension money is outside of your estate too which means it should never be subject to inheritance tax.

Q) How much can I pay into a pension?
A) Each year you can contribute an amount equal to 100% of your earnings into as many pensions as you like and still get tax relief. However this is subject to an annual allowance which has, somewhat controversially, been slashed in recent years.

In April 2011 the amount you can pay into a pension was reduced from £255,000 a year to £50,000 and at the start of the 2014/15 tax year it fell again to £40,000 where it stands today.

The allowance applies until you start accessing your pension. Once you have started taking benefits from your pension a new lower allowance called the money purchase annual allowance kicks in - this limits contributions to just £4,000 a year. This could be a vital consideration for savers to bear in bind if they plan to top up their pension with bonuses or inheritances towards the end of their careers. An exception applies if you are only cashing in a pension worth less than £10,000.

If you pay in more than the annual allowance you will be liable for a tax charge on the excess. However, the good news is that you can carry forward any unused allowance from the last three tax years to the current tax year, meaning you may be able to avoid the charge.

Non-taxpayers can pay into a pension and still benefit from tax relief at the basic rate (20%). You can pay in a maximum of £2,880 which then gets topped up to £3,600. You can also set up a scheme for a non-taxpayer and pay into it on their behalf (this might be a spouse or civil partner or a child or grandchild) and get tax relief at this rate.

Start a pension for your child

In addition to the annual allowance, which governs how much you can pay in each year, there is also a lifetime allowance. If the total value of your pensions exceeds this limit a tax charge will apply.

Again this allowance has been reducing over the years. In 2011 it stood at £1.8 million but fell to £1.5 million at the start of the 2012 tax year before falling again to £1.25 million at the start of the 2014 tax year. In April 2016 it fell to £1 million. This allowance now increases with inflation and in the year 2020/21 stands at £1,073,100.

Although the reductions have been made to target the wealthiest of individuals, experts have expressed concern that its not just extreme earners that will be caught out. Long-serving members of final salary schemes could be particularly vulnerable, even if they are only on a middle income.

Q) What happens to my pensions when I retire?
A) You can access your pensions any time from the age of 55. Traditionally pensions have been regarded as very inflexible savings vehicles, with strict rules governing what you do with the money you saved, however following the introduction of the pension freedoms in April 2015 savers can do what they like with their money. This is a massive change.

If you want the certainty of a fixed income you will still be able to purchase an annuity, or if you are happy to accept the risk of leaving your money invested you can enter into an income drawdown agreement. Here you keep your money in your pension but start taking an income from it. Alternatively you can cash in your pension and spend – or invest – the money as you choose.

What will you do with your pension?

Prior to these changes savers were essentially forced into buying poor value annuities that might only pay out a few pounds a week.

Up to 25% of any pension you cash in can be taken as a tax-free lump sum, however the remainder will be worked into your income for that year and you will be taxed at your marginal rate. So you will need to be mindful that by cashing in your pension you may put yourself into a higher tax bracket.

If you want to take your tax-free cash in one go you will then you will need to move the rest of your pension into a flexible drawdown plan.

First published on 16 April 2014

In reply to by anonymous_stub (not verified)

I’m really pleased with this article and impressed with the information included.. I’ve held a Liberty Sipp for the past year - with new pension provider Flying Colours - because they are local and advertised low fees but have been unimpressed with the quality of advice , performance and service I’ve received and am seriously considering transferring my funds to a new provider!

In reply to by anonymous_stub (not verified)

My wife currently only works part time and earns £10.800 pa, what is the maximum amount she can pay into a pension and get the government to top it up. I previous years she earned £13,500 and paid tax on that. Could we pay contributions based on that income for the preceeding 3 years. If so how do we go about it. Many thanks Colin

In reply to by anonymous_stub (not verified)

Regarding the State Pension: can I pay NICs retrospectively to make up for lost COPE years?

In reply to by anonymous_stub (not verified)

I fortunately saved assidiously in my 20's in to a personal pension scheme, saving the maximum that was allowed at that time (I think it varied between 15% & 1/6th my earned income during the 1980's). At that time I was a bachelor, earning a fairly decent sum for someone of that age and I had learn't through reading up just how important it was to start saving as early as possible for a pension and particularly before getting married having children etc when just about all families have their finances stretched to the limit in every direction. Youngsters starting out in employment today to the would do well to do as I did, as it meant that by the time I was 35 and got married and the same time gave up salaried employment with a hoped for view to become a successful entrepreneur, I had built up a reasonable starting block for a Pension and JUST AS WELL I DID! In my late 30's whilst trying to start a business, things never quite went to plan and the business took longer than I expected to start being profitable. Even then, in my early 40's I was unable to re-start any pension contributions until finally my self-employed earnings (when aged 43), started to exceed annual family expenditure and I made a couple of sizeable annual contributions, especially as it would keep me out of the higher rate tax bands and partially to make up for 8 years of zero contributions (knowing how important it was to keep contributing whenever possible),To my horror, aged 45, I was struck down with a rare painful spinal cord condition which paralysed me from the ribcage down and was left stuck in hospital for 2 long years during which time my wife, who up till then had been a full time stay at home mother with 3 young children to look after and my accountants tried to keep my business ticking over whilst question marks were being raised if I ever might recover sufficiently to continue working again. The doctors prognosis was not good. Of course they all stated that it very good mentally for me to be able to work somehow but they all agreed that an individual faced with my medical condition & long term handicaps would not be expected to have to work again, automatically qualifying me for Incapacity Benefit. However i was desperate not to lose my collapsing business, endangering all my employees livelihoods and making me wholly dependent on state benefits, something I would never have predicted would happen to me. My wife & accountant between them re-structured & shrunk the business to a more modest size, in the hope that we might be able to somehow keep it going and that I might be able to continue running it on a variable part time basis... otherwise I was completely unemployable due to unpredictable nature of having to cope with good days & bad days of my painful spine condition. In fact it took me 4 years to return home by which time the business was a 1/3rd its original size and on its knees but at least it had not "gone under" as we feared it might. Despite only being able to work a variable 5-20 hrs a week on the business, slowly but surely I managed to turn the shrinking business around and gradually return it to profit again but only being able to pay myself a very modest amount, whilst at the same time paying my wife, who was my full time carer & general helper (in every aspect of my life) a small salary from the business too. With 3 children still to support, we had to live very modestly compared to what we had hoped our lives would be when had got married 12 years earlier but we had no choice but to "keep going", working flat but still no spare funds for any pension contributions. Only once our children have began to hit the age of 18 and take responsibility for their own lives, were we in a position to resume pension contributions again, which we have been doing to the fullest extent possible in the last 5 years (I am now 59). Sadly though, I am now beginning to struggle with my medical condition and the business is also struggling too. Knowing I had a pension pot when we got married, my wife asked how much it was worth today (thinking it might be worth @£200-£250k). She was astonished when i told her that it was now worth just over £500,000 thanks t the compounding effect of starting a pension at an early and because of some astute pension fund investment choices in my part over the past 15 years considerably outperforming all market indices (and most fund managers too) + the benefit of rising global stock markets in the past 5 years. However even though it is now a sizeable sum, once I had done some calculations she was very disappointed when I said that I didn't think we could afford to retire unless we gave up our home which has been adapted for my wheelchair needs (to live in a much smaller 2 bed flat or bungalow) which neither of us want to do at this stage. I explained to her that whilst my medical condition is expected to reduce my likely lifespan by about 5 years, she (my wife) also currently aged 59 could easily live in to her 90's & beyond (& her mother is already heading in that direction). The £0.5m pension pot + £0.2m in ISA's would have to last that long! The other difficulty is that unless some UTI infection kills me off early (a common cause of death for those with spinal cord conditions), it is "more than likely" that in due course my medical condition would require me to go into a nursing home to provide me with "round the clock care facilities". Proper Nursing Care homes are expensive and Councils will always chase those with money to pay for the expensive care provide. Fortunately (as i understand it) Councils can force you to sell your home (or leave a hefty claim on its Sale value when the last of the 2 of us were to die) but they can't touch your pension (as it is deemed "outside your estate"). I would like to hopefully leave something to my children, thinking it so horrendously unfair that I was struck down both physically & financially struck down at the peak of my earnings capability quite early on in their childhood. Knowing that the Council could easily start chasing me or my wife or our combined estate for accruing nursing care home costs of @£40,000-£50,000 per annum for however many years I might be "in care", it occurred to me that I might be wise to delay touching my pension pot for "as long as possible" and trying to live off what other income producing assets we have in the meantime, whether it is the shrinking amount of income that we are making from our small business (or if closing the business simply receiving rent from the buildings where it is housed) or taking capital & income from our ISA's. I have two questions:a) would this be a wise course of action to take? Should we delay taking any money out of my pension for as long as possible.? Maybe I could start taking a percentage of each years accruing income within the pension pot( @2,5% per annum), whilst leaving the capital intact and re-investing the balance of the income into acquiring more capital units (or shares). Under the new rules could I do this and how would the income (say about £5,000 per annum) be treated by the Revenue? I have never fully understood which portion of any income from a pension is treated as returning capital (subject to no tax) and taxable income (if a higher rate taxpayer). Although the pension pot is in my name, can the income being distributed, be split equally between my wife and myself? Once I start drawing any sort of income from my pot (I deliberately had my pension pot divided up into numerous mini-policies), do I lose all the inheritance tax advantages of all my pension policies or just those that I have started drawing an income from. b) I am aware that once I hit the age of 75 (if I live that long), I can no longer avoid drawing an annual pension income from my pension policies. Under the old rules, you had to purchase an annuity, preferably one that would continue to pay a pension to my wife in the event of me dying first. However when the 2nd of the two of us were to die "that would be it - there would be no more capital left in the pension pot!" However under the new rules, as I understand it, unless you take out an annuity, you have to work to an agreed drawdown plan of say 7% per annum of the capital value of the pension at age 75, which each year, the drawdown being be made up of part capital and part income. In my time, I have been quite fortunate where I have invested my funds. If by chance I have continued to grow the capital base of trust at a rate faster than the draw down facility (I,e effectively preserving the capital), how would that capital be treated when the 2nd of the two of us were to die (say if by chance we both died before we were 80)? Would the capital left in the pension pot continue to benefit from the inheritance tax advantages (remaining "outside of the estate") that pension pots currently enjoy if death were to occur before the age of 75 and allow our children to receive whats left in the pension pot entirely tax free..... or .....are we left to the entirely ludicrous scenarios of one set of rules if death takes place before the age of 75 and another set of rules if death takes place after the age of 75? I am sorry for this long personal tale but I thought it would highlight to the young, the common sense of investing the maximum possible at a young age, knowing that later on with family expenses etc it becomes more difficult to make meaningful contributions to a pension & all the uncertainties that can occur if a critical illness strikes down a member of the family. It would also highlight the benefit & importance of monitoring the investment performance of your pension, selecting funds or shares to invest in carefully, treating it as no different as your ISA. Finally with all of us facing possibly ruinous expensive care home costs as we all live longer, your answer may make some approaching retirement think quite carefully how to balance which assets they should consider living off until they have no other choice but to start drawing down on their pensions. I await any answers or advice that any can give with interest,

In reply to by anonymous_stub (not verified)

HI I am taking my pension early due to redundency, both my and my partner ( not ,married) will not be working.I am looking to reduce my tax liabiltiy, (20%) is it possible to take out two pensions one for me and him , which I pay for and get tax relief on both ie £2880 topped up to £3600 X 2?Many thanks

In reply to by anonymous_stub (not verified)

My son works as a teacher within Europe will he get tax relief on his pension contributions

In reply to by anonymous_stub (not verified)

I live in Italy and therefore pay tax here. Can I open a Pension in the UK..?

In reply to by anonymous_stub (not verified)

Thanks for your question. Your wife will only need to pay income tax on the remainder of her pension if her total income for the year exceeds her personal allowance - currently £11,500. Hope that helps.

In reply to by anonymous_stub (not verified)

My wife is taking her pension early do to ill health. She has been an none taxpayer for 6years as she receives no state benefits at all due to our savings and my income. We know she can get 25% of her pension pot tax free but can she increase this payment tax free to include her yearly tax allownce

clause 11 rule

why is this subject taboo?

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