“Tax Relief” is a term thrown around in the UK, but it is rarely broken down and explained in an understandable manner. It applies to pension contributions, donations to charity and a couple of other circumstances. This article will focus on tax relief and its connection with pension contributions.
To entice UK individuals to contribute into pension vehicles, the government allows most contributions into a pension to receive something called “tax relief”. This basically means that money may enter your pension, and if any tax had been deducted from that source of money, this gets added back into the pension as well. In essence, the government is saying we will add back any tax deducted from the money entering your pension. Lets try an example:
Mrs Penelope Shun has a salary of £40,000 per annum. All things equal, this means that Penny will receive over the year around £30,583 net of tax and National Insurance contributions. Penny saves this money in her bank account. Penny is smart, and would like to contribute money in to her Wealthsimple Pension to fund a comfortable retirement. Say Penny contributes £10,000 of her savings into her pension. As we know, this contribution will receive tax relief. The government notices that the money that Penny is contributing into her pension has been taxed (remember, her salary was £40k but she received much less, due to tax) therefore they will pay back the tax on this money into Penny's pension. Penny is a basic rate tax payer, who pays 20% tax on her income. This means the government will pay back this tax, by way of increasing the pension contribution by 25%.
25% I hear you cry!? But Penny only pays tax at a rate of 20%?! This is the difference between a net contribution and a gross contribution. A net contribution can be defined as the money that leaves your bank account to fund the pension contribution. This money is then “grossed up” with the tax relief, to enter the pension. The gross contribution in this example is £12,500. This gross pension contribution includes the tax relief of 20%, as 80% of £12,500 is £10,000.
Now, if Penny was a 40% tax payer, she would receive tax relief at a rate of 40%. Penny would need to perform the exact same procedure as the above, in terms of contributing £10,000 and this entering the pension as the gross £12,500 figure. However, to obtain the additional 20% of tax relief, Penny would need to file a tax return, and enclose that she made this pension contribution. At this point, HMRC (the UK taxman, for want of a better word) would recognise Penny is indeed entitled to additional tax relief, and would pay this by way of a tax rebate, into her bank account. This means that Penny's net contribution in this case is £7,500.
The process is exactly the same if Penny were to be an “Additional Rate” tax payer (The highest bracket of tax in the UK - 45%). Penny would need to follow the exact same process as above, and then record this contribution on her tax return. Penny would receive an even larger tax rebate. Penny is smart.