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How are pensions taxed in the UK?

In the UK, private pension saving is taxed on an “exempt, exempt, taxed” model. This means:

  • When people and their employers pay into a pension the contributions are exempt from taxation. Both the saver and any contributing employer receive tax relief, up to set limits.
  • If the pension savings grow through investments this is exempt from taxation.
  • When the savings are withdrawn as pension payments these are taxed like other income. People are allowed access up to 25% of their pension savings tax free.

What are the limits on pensions tax relief?

There are three main limits on the amount of tax relief someone can receive when they are contributing to their pension. In 2022/23 these were:

  • A person earning more than £3,600 a year in the UK cannot receive tax relief on pension savings worth more than those earnings.
  • An annual allowance which limits the amount someone can save into a pension pot before they pay tax. This is £40,000 a year for most people.
  • A lifetime allowance is the amount which someone can usually build up in pension pots without paying tax. This is currently £1,073,100.

What changes have been announced?

For employees there are two ways to administer tax relief on pension contributions:

  • Net pay: pension contributions are deducted from earnings before any tax has been paid. This means that tax relief is automatically given at the person’s rate of income tax.
  • Relief at source: pension contributions are made after tax has been paid. Tax relief is claimed by the pension scheme at the relevant basic rate of income tax (20%).

People paying below the basic rate of income tax will receive more tax relief if they contribute to their pension through relief at source than through net pay.

The Government announced in October 2021 that it will “resolve the anomaly by introducing a system to make top-up payments directly to low-earning individuals saving in pension schemes using a net pay arrangement from 2024-25 onwards.”

What are the options for reform?

Two allowances or one?

There have been questions about whether both an annual and lifetime allowance are needed when they both have the same aim, to limit the amount of tax relief someone can receive.

In July 2018, the Treasury Committee recommended that “the Government should give serious consideration to replacing the lifetime allowance with a lower annual allowance, introducing a flat rate of relief, and promoting understanding of tax relief as a bonus or additional contribution.” In response, the Government said that “no consensus” for reform had emerged since it consulted on the issue in 2015.

A single rate of pensions tax relief

One option for reform is a single rate of tax relief, rather than relief being given at someone’s marginal rate of tax. Those in favour of a single rate of pensions tax relief often argue that it would be fairer for all taxpayers to receive the same rate of relief. Under the current system higher rate income taxpayers receive a higher rate of pensions tax relief. Those opposed to a single rate of tax relief argue that it would be expensive to administer, unfair and inappropriately distort behaviour.

Taxing pension contributions

In the UK, private pension saving is taxed on an “exempt, exempt, taxed” model (EET). This means that tax is not paid on contributions and investment growth, but tax is paid when savings are used to make pension payments. A different approach which has been considered is a “taxed, exempt, exempt” model (TEE). In this system contributions are taxed like other salary and no tax is paid on investment growth and payments from savings.

Those in favour have said that the current system is expensive. Opponents however have argued that the transition to a new system would be complex and taxing contributions would disincentivise pension saving.

Limiting tax-free lump sums

People are allowed to receive up to 25% of their pension savings as a tax free lump sum when they access their pension. Whether this is possible in a particular case will depend on the rules of the specific pension scheme. Several bodies have suggested that the amount which can be withdrawn tax free should be capped at a level below 25% of the lifetime allowance.

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