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How are pensions taxed in the UK?

In the UK, private pension saving is taxed on an “exempt, exempt, taxed” (EET) 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  • When the savings are withdrawn as pension payments, these are taxed like other income.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 limits on the amount of tax relief someone can receive when they are contributing to their pension. In 2022/23 these were:

  • A person can receive tax relief on pension contributions of up to 100% of their annual earnings. Someone earning less than £3,600 a year can receive relief on contributions up to £3,600.
  • An annual allowance, which limits the amount someone can pay into a pension pot to £40,000 each year before they pay tax. This allowance is tapered (reduced) for people earning more than £240,000 including pension contributions. The minimum annual allowance someone with tapering can retain is £4,000.
  • A lifetime allowance of £1,073,100, which is the total amount someone can usually build up in pension pots without paying tax.
  • Once someone withdraws savings from a defined contribution pension, the amount that they can contribute to defined contribution schemes and receive tax relief on in future is reduced to the money purchase annual allowance of £4,000 a year.

The way pension tax rules are applied can depend on the type of pension scheme. More detailed information about these allowances is available in the Commons Library briefing Pension tax relief: The annual allowance and lifetime allowance.

What was announced in the 2023 Budget?

The Chancellor announced changes to pension allowances, so that from 6 April 2023:

  • The lifetime allowance would be abolished
  • The annual allowance would increase from £40,000 to £60,000
  • The adjusted income when the tapering of the annual allowance for high earners begins would increase from £240,000 to £260,000 and the minimum annual allowance someone with tapering can retain would increase from £4,000 to £10,000
  • The money purchase annual allowance will increase from £4,000 to £10,000

The maximum amount someone can withdraw from a pension tax free will remain at £268,275 – 25% of the lifetime allowance in 2022/23. Above this, income from pensions will be c liable to income tax, charged at the individual’s marginal rate, but will not be subject to additional taxes.

In his Budget Speech, the Chancellor cited concerns about the impact of pension taxation on senior NHS clinicians. These are covered in the Commons Library briefing Public service pensions: Impact of pension tax rules on NHS consultants and GPs

What are the options for further reform?

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.

National insurance Contributions

The Institute for Fiscal Studies, a UK economics research institute, has proposed changing how employee and employer National Insurance Contributions interact with pensions tax relief. It has suggested that employee NICs should align with the pension tax relief approach for income tax and that employers receive tax relief in the form of a subsidy for their pension contributions instead.

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