Tax benefits of saving in a pension

Paying into a pension attracts tax relief*. This means that the government also contributes to your pension.

Individual pensions - how tax relief works

If you have an individual pension your contributions are paid into your fund after tax has already been charged. To offset this, the taxman contributes an amount depending on your tax status subject to HMRC limits.

• For every £80 a basic rate taxpayer pays into a personal pension the taxman will add £20.*
• For every £80 a higher rate taxpayer pays in a personal pension the taxman will add £20. But at the end of the tax year you can claim back a further 20%, in this case £20, so the cost to you would only be £60.* You can do this through a self-assessment tax form and can use the money to pay more into your pension if you wish, although you don't have to.

Company pensions - how tax relief works

If you have a money purchase company pension (also known as a defined contribution scheme) or a contributory defined benefit pension, where you make payments into your fund, tax relief is the same but works in a slightly different way.

If you pay contributions these are deducted from your salary before tax is taken, thereby reducing your gross salary. As income tax is based on your pay after deducting your contributions you automatically receive tax relief at your highest rate.

• As a basic rate tax payer you get 20% tax relief for every £100 paid into your pension. For each £100 contribution, your take-home pay is reduced by £80.
• As a higher rate tax payer you get 40% tax relief for every £100 paid into your pension. For each £100 contribution, your take-home pay is reduced by £60.

Group personal pensions are sometimes categorised or referred to as a company pension schemes because they are set up by employers. However, technically speaking they operate like individual pensions in the way that tax relief is applied.

Tax relief

You can see the benefits of tax relief in the charts below. As the chart on the right shows, the effect of tax relief on pension payments over time is considerable.

In an individual pension your higher rate relief is not paid into your plan. Instead you need to claim it back at the end of the tax year. So for example, you would need to initially pay in £80 to have £20 in basic rate tax relief added automatically to your pension. Then, at the end of the tax year, you can claim back an extra £20 as higher rate tax relief. In a company pension, your higher rate relief is automatically paid into the scheme.

The charts above represent a simplified model where all earnings are taxed at 20% as a basic rate taxpayer, and at 40% as a higher rate taxpayer. In reality some income would remain untaxed at the basic rate, and some income would be taxed at the basic rate for the higher rate taxpayer. These figures assume no other deductions such as National Insurance Contributions and are to illustrate how tax relief is obtained. You can also try our tax relief calculator to see how tax relief works. Note that there are limits on the amount of tax relief your contributions can benefit from - read about the tax allowances.

Note that pensions in payment are taxed as earned income.

What happens if you don't pay any tax?

You can still benefit from tax relief on contributions you make but only up to a limit of £2,880. The taxman will add 20% on this to make the total £3,600. There is no tax relief for contributions over this amount.

Other tax benefits

• Your pension fund doesn't pay tax on any capital gains or investment income.
• When you take your benefits at retirement you can take up to 25% of it as a tax-free lump sum (depending on your pension scheme rules, your age, and tax allowances), although any annuity income will be taxed as earned income.

For more on tax relief and pensions visit the government website Directgov.

*This is based on our current understanding, as at 6 April 2011, of current tax legislation and HM Revenue & Customs practice, both of which may change without notice. The impact of taxation (and any tax relief) depends on individual circumstances.