Why paying into a pension fund is so tax efficient

What is a pension?

There are three different types of pensions:

• Defined contribution – a pension pot that is based on how much is paid in (either by yourself or yourself and your employer).
• Defined benefit – this is typically provided by an employer and is based on your salary and how long you have worked for the business. Some employers may require you to contribute also.
• State pension – a pension provided by the state based on your national insurance contributions.

Whilst you are unable to opt-out of making national insurance contributions towards a state pension (so long as you are earning above the threshold), both defined contribution and defined benefit pension schemes are tax-efficient ways to save money for when you want to retire. You put money into a pension pot (or multiple pots) which is managed by a pension provider. The pension provider is responsible for investing that money until you access it so that your pension pot can grow in value. As with all investment, it is important to acknowledge that there is always a risk that the investments can fail and lose money as well as have the potential to make money. However, any money made from the investment is exempt from tax (whilst it remains in the pension fund) as well as any money you put into the pension. You are normally only allowed to access your pension fund at the age stipulated by the pension provider (this is usually from the age of 55) which is different from the state pension age.

Why is saving into a pension fund important?

Saving into a private pension fund, whether that’s under a workplace pension scheme or a personal private pension scheme, is important because it is unlikely that the state pension will be sufficient to cover all your costs when you come to retire. For the tax year 202/25 the full state pension is currently £221.20 per week and only accessible when you reach the age of 66. Furthermore, the state pension age is due to increase to age 67 between the years 2026 and 2028, and further increase to age 68 between the years 2044 and 2026. If you want to retire before this age, you will need a private pension.

Saving into a pension fund is important as it will also allow for greater financial security later in life when you may not be receiving regular earnings or as high an income as before. This does not necessarily mean you must stop working if you are receiving a pension, and many people will choose to do both. However, with a comfortable pension fund, you’ll have the financial freedom to do other things without being too concerned about money or work such as:

• Be able to travel
• Spend time with family or help with childcare
• Learn a new skill or take up a hobby
• Volunteer with charity work or even switch career to something that may pay less than your previous job
• Look after your health and wellbeing

What are the tax advantages of paying into a pension?

There’s a reason why accountants often advise clients to make pension contributions when they’re looking for ways to save on tax, and that’s because there are multiple tax advantages when you pay into a pension. For high-net-worth individuals in the higher rate and additional rate income tax bands, paying into a pension plan will not only boost your pension pot for when you come to retire, but can also make a real difference to your finances by reducing your tax liabilities. Here are 5 tax advantages of paying into a pension:

1. Increase your basic rate income tax band

The basic rate income tax is charged at 20% which is significantly lower than 40% and 45% for higher rate and additional rate taxpayers respectively. However, it is only applied to income up to £50,270, which means your earnings above this are almost halved by income tax deductions. The first advantage of paying into a pension is that you can extend your basic income tax threshold past £50,250 when you make pension contributions. It works by allowing you to extend the threshold by as much as you put into a pension fund. For example, if you pay £10,000 into a pension, your income up to £60,250 will be taxed at a rate of 20%, allowing you to keep much more of your earnings. You can also achieve this outcome by making charitable donations. It is important for us to highlight that this is only an advantage if you’re paying the higher or additional income tax rates.

2. Receive government top up to your pension pot

To encourage people to make pension savings, the government offers a cash incentive. The government offers an additional 25% of however much you have put into a pension pot as a cash top up (this equates to 20% at source). For example, if you put £1,000 into a pension fund, the government will add an extra £250 (£250 is 20% of the total £1,250).

For higher rate and additional rate taxpayers, there is a further tax advantage when paying into a pension as the government will add the difference between the basic rate and the higher and additional rate as tax relief. Higher rate taxpayers will receive 20% as a basic rate threshold extension and additional rate taxpayers will receive 25%. Using the same example of putting £1,000 into a pension plan, a higher rate taxpayer will also receive £250 as a cash top up, but then additionally receives £250 as tax relief (needs to be claimed through a self-assessment tax return). This means they’ll be taxed at 20% for earnings up to £50,520. The same applies for additional rate taxpayers, but they would receive 25% tax relief and therefore extend their basic rate threshold to £50.582.50.

3. Grow your pension pot with tax-free investments

As briefly mentioned above, one of the big benefits of saving into a pension is that the investments made are tax-free. This is unlike other types of common investments you may also have such as stocks, bonds, gilts, or investment property that pays rental income which are all subject to income tax or dividend tax. There are some alternatives which also offer tax-free investments but have more limitations or disadvantages than pensions. For example, ISA allows for tax-free savings, but you are only able to put in a maximum of £20,000 per tax year. SEIS and EIS investments also offer valuable tax advantages, yet are usually much higher risk than pension savings. Not only that, but because pension savings are intended to be much longer term investments, your pension pot can benefit from compound interest.

4. Leave your pension to beneficiaries inheritance tax free

Did you know that another tax advantage of paying into a pension is that your pensions plans do not fall within your taxable estate? That means that when you die, you can pass your pension onto beneficiaries inheritance tax-free (inheritance tax is charged at 40%). The rules of what happens to your pension when you die are complicated, and will depend on how old you are, the rules of your pension provider, and whether you have started accessing it or not (or chosen to buy an annuity with your pension fund). However, in general, if you die before the age of 75, your beneficiaries are able to receive a lump sum of your pension 100% tax-free. If you die after the age of 75, your beneficiaries are able to access your pension at the rate of their income tax band. For beneficiaries in the basic rate income tax band, it’s a significant 20% tax saving from the otherwise 40% inheritance tax rate.

The rules on being able to leave your pension inheritance tax-free is due to be scrapped come April 2027. The means that any unused pension funds will fall into the deceased’s estate.

5. Access a tax-free lump sum tax-free when you retire

So, as we’ve explained, any money that is put into a pension pot is tax-free. Whilst your provider is investing the funds, any gains made are also tax-free whilst it remains in your pension plan. However, when it comes to accessing your pension, this is when your pension may be subject to tax as you do have to pay tax on your pension income. Nevertheless, for most pension plans, you’re able to take 25% of pension as a lump sum completely tax-free. What’s more, if you are accessing your pension pot, but taking less than your annual personal allowance, then this will be tax-free also. HMRC explains the different ways the 25% tax-free withdrawal will work depending on the type of pension you have.

How to pay into a pension

The most popular way to pay into a pension is through the workplace pension scheme because it is a legal requirement for all employers to automatically enrol employees when they first join. You always have the option to opt-out (usually by telling your employer or provider by writing). When you’re enrolled onto a workplace pension scheme, your employer will make deductions from your wages on your behalf and pay it into the pension scheme. You must contribute a minimum of 5% of your salary to a workplace pension scheme, and your employer must make a minimum contribution of 3%. Some employers will offer to match your pension payments up to a certain amount. You can also choose to top up your pensions with a lump sum whenever you like.

If you are self-employed, you may choose to set up a private pension. You’ll choose a provider that suits your needs, and this may be determined by whether they require you to make regular monthly payments or allow you to pay in lump sums as and when you can.

How many pension pots can I have?

You can have as many different pension funds as you like, and there is no limit to the number you can have. In fact, an advantage to having multiple pension funds is that by doing so you are diversifying your investments, which is one of the best ways to mitigate risk. However, having many different pension plans can make it challenging to manage, so you may choose to amalgamate your old pensions into one. Do check that there are no penalties or charges before doing this. This can be helpful to those who may have many old workplace pension schemes, as when you leave an employer, your pension plan will close but still belong to you and be accessible when you retire.

What is the maximum I can put into a pension?

Since the 2023 Spring Budget, the Chancellor abolished the lifetime pension allowance which previously allowed you to put in a maximum of £1,073,100 over the course of your entire lifetime. Doing this encourages people to work for longer in order to keep putting savings into a pension scheme without being disqualified for doing so. You can take advantage of this by making pension contributions as early in your life as possible.

Despite the removal of the lifetime pension allowance, there are still regular restrictions to how much you can put into a pension scheme. The annual allowance is capped at the maximum of your relevant earnings or £60,000 (whichever is lower). For the most part, your relevant earnings are your salary. So, if your annual salary is £35,000, the maximum you can put into a pension plan for the year is £35,000. Conversely, if your annual salary is £75,000, the maximum you’ll be able to put in is £60,000 for the year. If you’re a director of your own limited company, then you may only be taking a small salary and topping up your income by dividends. However, you can get around this by using your company to pay for your pension contributions and so would be allowed to put in a maximum of £60,000 a year as well.

Relevant earnings do not include any savings, rental income or dividends you may receive throughout the year which would ordinarily increase your income. However, income generated through furnished holiday lets is included within the scope of relevant earnings.

Can I withdraw money from my pension early?

It is possible to withdraw funds from your pension early (before the age of 55), however there are heavy tax disadvantages to doing so. It is not advised unless under specific circumstances. Whilst it is not illegal to withdraw money from your pension early, there are hefty charges involved to discourage people from accessing their retirement savings early. Firstly, you’ll be charged 55% income tax on any amount you have taken, and usually there are additional charges of around 30% to allow you to do so. This would mean that you would only be left with 15% of whatever you initially intended to take out, so consider this option very carefully before doing so. The one exception to when you can withdraw the entirety of your pension early tax-free early is if you are terminally ill and have a life expectancy of less than a year.

Is my pension taxed?

When the time comes where you choose to start releasing your funds from your pension for retirement, you will usually be allowed to withdraw a lump sum of up to 25% tax-free. Any withdrawals after this which exceed your personal allowance will be taxed at your income tax rate. If you are only receiving income from your pension, your tax will be deducted at source (similar to how employers deduct your income tax from your wages before you receive it). If however, you have other sources of income, then you will need to declare your pension income tax due through a self-assessment tax return.

Get help with your pension

If you need advice with your pension, we recommend Pension Wise which is a government-backed service that offers impartial advice to over 50’s. If you’re looking for help with your tax return to declare pension income as well as other income, then please complete a contact form for a no-obligation personalised quote.