Tax Relief on Pension Contributions: What Employers Need to Know

Tax relief on pension contributions isn’t just a nice perk for your staff; it's a powerful incentive that encourages employees to save for their future. And, in return, you and your employees pay less tax now.   

It’s a critical aspect of retirement planning and a practical win-win, benefiting both employees and employers in the UK. 

Let's break down how pension contributions and tax relief work together, including the different types of UK pension tax relief available - namely relief at source, net pay arrangement and salary sacrifice. We’ll also look at how this can boost your company’s finances. 

What is Pension Tax Relief?

You can think of tax relief on workplace pensions as the government's way of saying "thank you" for saving for your retirement. By offering employees a rebate on taxes, the government makes it more affordable for your team members to stash away funds for later life. 

Essentially, it reduces the amount of tax they have to pay on their income, meaning more money goes to their pocket instead of the taxman (or woman). The relief is automatically applied to pension contributions, effectively increasing the value of any money set aside for retirement - sounds good, right?

How Does Pension Tax Relief Work?

When an employee contributes to a pension scheme, the government adds a certain amount of money to their contribution as a way of refunding the taxes paid on that income. Let’s take a look at how this pans out with a practical example of tax relief on pension contributions.

If an employee is a basic rate taxpayer, for every £80 they contribute, the government adds another £20, making their total contribution £100. This is because £100 of their earnings would have incurred £20 of tax at the basic rate of 20%.

What are the different methods of pension tax relief? 

The basic concept is pretty straightforward. However, there are three different ways companies can apply tax relief to pension contributions, and they are:

Salary Sacrifice 

Salary sacrifice reduces gross pay by the amount of the pension contribution, which in turn reduces the pay on which you calculate:

• Tax

• Employee and employer national insurance

This is both a tax-efficient and cost-effective way of deducting both employee and employer pension contributions. Remember, when you set up a salary sacrifice scheme, it's important that:

• Employees agree to enter into a salary sacrifice arrangement, as this effectively reduces their gross pay.

• You recognise that employee eligibility for things such as statutory sick and statutory maternity pay may be impacted.

• National Minimum Wage (NMW) is calculated on post-sacrifice earnings. It’s illegal to reduce an employee to below the minimum wage because of their salary sacrifice deductions.

Net Pay Arrangement

Processing pension deductions through a net pay arrangement is where pension deductions are taken before the tax calculation, lowering gross taxable pay.

This arrangement doesn't provide a National Insurance saving for the employee or employer.

Here are a couple of things to consider about net pay arrangements:

• Relief is given at the rate of tax the employee pays.

• As a result, no relief is available if an employee doesn't pay tax.

Relief at Source

Relief at source is the process where pension deductions are taken from net pay after the deduction of tax.

In other words, 80% of the employee's pension deduction will be taken via the employee's pay, and the remaining 20% will be automatically reclaimed by the pension provider, which is then added to an employee’s pension pot.

The 20% tax relief will still be given if the employee has not paid tax in the tax year due to their earnings falling below the annual threshold.

A few things to keep in mind if you’re operating relief at source:

• The month-to-month cost is higher for an employee and employer as deductions are taken after the calculation of tax and National Insurance.

• The annual savings are still lower than those of a salary sacrifice arrangement as there is no National Insurance relief.

• Relief is paid straight into an employee’s pension, unlike salary sacrifice arrangements.

• Employees in higher tax brackets need to reclaim any additional tax relief via self-assessment.

What impact does each tax relief have on payroll?

Tax relief on pension contributions: FAQs

Do pension contributions reduce taxable income in the UK?

Yes, particularly under the net pay arrangement where contributions are deducted from salary before it is assessed for tax. This lowers taxable income, which can be beneficial, especially for higher-rate taxpayers.

What is the maximum contribution to a pension in the UK?

For the 2024/2025 tax year, the annual allowance for pension contributions is £40,000. This is the maximum amount of money an employee can contribute to their pension in a year while still receiving tax relief. It includes both your contributions and any contributions made by you, the employer.

What are the benefits of tax relief on pension contributions?

Tax relief on pension contributions offers several benefits, including encouraging retirement savings, helping to increase pension pots and reducing taxable income, particularly under net pay arrangements.

Never fret about pension tax relief again

Handling pension contributions and ensuring that tax relief is correctly applied can lead to worry for your HR team. But that’s where PayFit steps in.

Our cloud-based payroll solution takes care of pension contributions, and we can automatically process pension submissions and tax relief for all major UK providers. But it doesn’t stop there. We can also ensure all eligible employees are auto-enrolled onto your pension scheme and that all tax calculations are performed swiftly and accurately. That’s tighter compliance,  more peace of mind and less worry for your team.