Pension contributions are exempt from income tax, as are investment returns within a pension fund. When a pension is accessed, 25% can be taken free of tax, with the remainder being subject to income tax. Individuals’ pension contributions are made out of income that has been subject to National Insurance contributions (NICs), but no NICs are charged on pension income. Employer pension contributions, however, do not incur NICs at any point – and will not incur the new health and social care levy – and are therefore especially tax-advantaged. There are additional tax advantages for pension pots bequeathed at death. There are lifetime and annual limits on the amount that can be saved free of income tax in a pension, both of which have been reduced significantly since 2011.
Private pensions in the UK fall into two broad categories: defined-benefit (DB, also termed salary-related) and defined-contribution (DC, also known as money-purchase). Pension contributions can be made by individual savers or by others on their behalf: the majority are made by employers on their employees’ behalf.
Pensions and income tax
- income that is paid into a private pension is exempt from income tax;
- income earned from investments within the pension fund is also exempt (and capital gains are exempt from capital gains tax);
- money received from the pension is taxed.
This is often referred to as ‘exempt-exempt-taxed’ or ‘EET’ treatment.
In effect, income tax on earnings paid into a pension is deferred from the time the contribution is made until the time the earnings (along with any returns accrued in the meantime) are withdrawn from the pension. It is as if individuals, rather than receiving their earnings in full now, agree to get part of their earnings in future instead, and income tax is levied when that deferred remuneration is actually received.
If someone faces a lower (higher) income tax rate when they receive their pension income than when the pension contributions were made, then they will pay less (more) income tax as a result of deferring their income in a pension. For example, many people who are higher-rate taxpayers when making contributions (and therefore receive 40% income tax relief on their pension contributions) will be basic-rate taxpayers in retirement (and therefore pay only 20% income tax on their pension income).
There are two exceptions to this EET treatment. The main one is that people can choose to take 25% of their pension free of income tax. This means that 25% of the income saved in a pension never incurs income tax, either on the way in or on the way out. (This is known as ‘exempt-exempt-exempt’ or ‘EEE’ treatment.) The vast majority of pension savers will take 25% of their pension free of income tax. This is one of the main ways in which pensions are tax-advantaged relative to other forms of remuneration and savings. The second exception to EET treatment is that pensions bequeathed before the age of 75 are entirely exempt from income tax in the hands of the recipient (and therefore also EEE). The gradual shift that is taking place from DB to DC pensions and the introduction of ‘pension freedoms’ in 2015 (giving people more flexibility to use their DC pension savings in ways that result in the pension pot being bequeathed) mean that this exemption will become more important over time.
There are two ways that income tax relief on individuals’ pension contributions is administered: a ‘net pay’ arrangement, where pension contributions are made out of earnings before income tax is paid (so that the pension contribution is excluded from taxable income), and a ‘relief at source’ arrangement, where individuals’ pension contributions are made out of after-tax income and income tax is reclaimed from HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more. For most pension savers, which arrangement is used does not affect the amount of income tax relief received, but the different arrangements do have different implications for non-taxpayers and for some Scottish taxpayers.
Tax on pension income is collected as tax on employment income: pension providers deduct income tax through the Pay-As-You-Earn (PAYE) system before making pension payments, but many pensioners have to fill in a tax return each year to ensure that the correct amount of tax is paid.
Pensions and NICs
National Insurance contributions are never levied on income from savings and investments, and that includes pensions. Thus, like income tax and capital gains tax, NICs are not levied on investment returns within pension funds. Unlike income tax, NICs are not charged on any income received from the pension either (in effect, pension income is treated as savings income rather than deferred earnings for NICs purposes).
Whether pension contributions are subject to NICs depends on the type of pension contribution.
Private pension contributions made by an employee or self-employed person cannot be deducted from earnings for NICs purposes: that is, individuals’ pension contributions are made out of their after-NICs income. This treatment is consistent with the fact that future pension income is not subject to NICs. Individuals’ pension contributions are thus taxed up front but not thereafter: they have ‘TEE’ treatment.
In contrast, employer pension contributions are not included in earnings for NICs purposes. This means that remuneration in the form of employer pension contributions escapes NICs altogether: there are no NICs on the earnings paid into the pension, and no NICs when the money is received from the pension either (they have ‘EEE’ treatment). In overall revenue terms, this is by far the biggest tax break for pensions. The new health and social care levy will work in the same way, further increasing the tax break provided for employer pension contributions.
The fact that NICs treat employer pension contributions more generously than employee contributions goes some way to explaining why the majority of private pension contributions are made by employers. Indeed, in some cases, employees and employers explicitly agree to take advantage of the opportunity: if their employer is willing, employees can enter a ‘salary sacrifice’ arrangement, where they reduce their gross salary in exchange for higher employer pension contributions. This means someone with the same overall gross remuneration and the same total pension contribution can reduce how much they (and their employer) pay in NICs by reducing their employee pension contributions and increasing their employer pension contributions.
Annual and lifetime allowances
There are annual and lifetime caps on the amount that can be saved in a pension free of income tax. These were introduced in 2006 (replacing a swathe of more complicated arrangements) and have been greatly reduced since 2010.
For most people, the annual allowance limits tax-free contributions to £40,000 (or the greater of £3,600 and 100% of earnings if that is lower than £40,000) per year. But the annual allowance is lower for the highest-income individuals and for those who have already taken money from their pension in certain ways.
In addition to the annual cap on contributions, there is a lifetime allowance – £1,073,100 in 2021–22 – which the total value of an individual’s private pensions cannot exceed without attracting extremely high tax rates.
Tax treatment of pensions on death
When someone dies, what happens to their pension depends on the type of pension scheme.
- DB schemes often pay some benefits to a surviving partner or other dependants. These payments are liable to income tax at the recipient’s tax rate.
- For DC pensions where there is still a balance of funds (i.e. not an annuity), the person inheriting the pension pot can choose when and how to draw the funds out of the pension (e.g. as a lump sum or gradually). If the individual was 75 or older when they died then the payments to the beneficiary are liable to income tax at the recipient’s tax rate whenever they choose to take the money. But if the individual died before age 75 then such withdrawals are entirely free of income tax.
Pensions that are bequeathed are effectively exempt from inheritance tax: they are not included as part of deceased individuals’ estates when inheritance tax assessments are made (except in special, easily avoidable, circumstances).
What are the tax advantages of pensions?
When thinking of the tax advantages of saving in a pension, many people’s first thought is of income tax relief on pension contributions. But much of this up-front relief will be offset by the income tax eventually charged on pension income. These two elements should be considered together. There is tax relief on pension contributions precisely because the resulting income is taxed; it would be absurd to tax both income paid into a pension fund and income received from it. The income tax on earnings contributed to a pension is merely deferred until the money (along with any returns earned in the meantime) is received from a pension.
In some cases, deferring income tax until retirement makes no difference to the value of the tax ultimately paid by taxpayers and received by the government. In other cases, deferring tax until the pension is received means that people pay tax at a lower (or higher) rate in retirement than they would have faced if taxed up front on the earnings contributed to a pension.
It is debatable whether those people who face a lower tax rate in retirement than in working life should be regarded as receiving ‘tax relief’; this depends on the benchmark against which the current system is judged. They are certainly paying less tax than they would if tax were levied up front on earnings contributed to a pension. But there is a good case for only applying tax when money is available to spend, and against this benchmark the fact that their tax rate would have been higher if tax were levied earlier would not be viewed as tax relief.
The second tax ‘advantage’ often attributed to pensions is that there is no income tax or capital gains tax levied on investment returns within pension funds (tax is only paid when the money is withdrawn). Again, that is a tax relief compared with a benchmark system in which all income is taxed when it accrues, but it is debatable whether that is the most appropriate benchmark. In practice, the returns accruing on most other assets (notably including owner-occupied housing and Individual Savings Accounts (ISAs)) are not taxed (or not taxed in full) either.
Four other features of the current system provide tax breaks for pension savings (and these are tax breaks regardless of which benchmark the current system is compared with):
(i) No NICs are levied on employer pension contributions (either when the contribution is made or when the money is withdrawn from the pension).
(ii) 25% of a pension can be withdrawn free of income tax, and thus never incurs any income tax.
(iii) There is no income tax charged on inherited DC pensions if the pension holder dies before age 75.
(iv) There is no inheritance tax payable on bequeathed pension wealth.
In revenue terms, the lack of any NICs on employer pension contributions is by far the biggest tax advantage for pension saving. It has also grown as NICs rates have increased.
How much does pension tax relief cost?
HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more publishes widely cited estimates of the cost of pension tax relief. HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more highlights that this is not the tax yield that would be expected from withdrawing tax relief or changing the tax treatment of pensions, as there would be significant changes in behaviour. However, even with that caveat, these figures are easily misinterpreted and should be used with care.
The cost of NICs relief ((i) above) is relatively straightforward, at least assuming a fixed level of pension contributions. HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more estimates that in 2019–20 the government gave up nearly £20 billion that it would have collected if the employer pension contributions made in that year had been subject to employer and employee NICs.
Income tax is more complicated. HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more estimates that in 2019–20:
- income tax relief on pension contributions was £34 billion;
- income tax relief on investment returns within pension funds was £7 billion;
- income tax collected on pension income was £19 billion.
HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more concludes that net income tax relief for pensions that year was £22 billion (34 + 7 – 19); coming on top of £20 billion NICs relief, that makes a total of £42 billion. However, there are a number of caveats and limitations which ultimately make that £22 billion figure more misleading than enlightening.
First, the HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more figures compare the income tax relief given to today’s savers with the income tax levied on today’s pensioners. That provides an estimate of how much income tax revenue the government is forgoing in a particular year, but it is not a good estimate of how generous the system is to either the current generation of savers or the current generation of pensioners. Ideally one would want to calculate, for each individual, the total amount of tax they would pay on their pension saving over their entire lifetime given the current tax system, and compare that with how much they would pay under an alternative (benchmark) system. By instead comparing tax relief for current savers with tax from current pensioners, the HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more figures ignore the fact that the number of people in each cohort, the size of their pension funds and the tax policies in place at different times in their lives are very different. If pension income will be higher in future (e.g. because there will be more pensioners than there are today), these figures will overstate the cost of pension tax relief.
Second, the HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more figures compare the current income tax treatment of pensions with one particular alternative. Specifically, they are calculated compared with a system in which tax is levied on earnings paid into a pension and on investment returns within a pension, but not on pension income (‘TTE’ treatment). That is one reasonable benchmark, albeit a benchmark system that would actively discourage saving and is harsher than the treatment applied to most other savings. But, as we have noted above, there are other reasonable benchmarks (e.g. one could compare with a system in which income was only taxed when it was available to be spent (an ‘EET’ system) or one in which earnings were taxed but the return to savings not (a ‘TEE’ system)). Different comparisons would yield very different estimates. The HMRCHer Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.Read more figures do not disentangle the cost of allowing 25% of a pension to be accessed tax-free or of the income tax exemption for pensions inherited from under-75s ((ii) and (iii) above, both of which would be counted as reliefs against any alternative benchmark).
Third, £7 billion is an underestimate of the tax forgone on investment returns within pension funds. It is calculated assuming income tax relief at the basic rate of tax, while in reality many of the returns will accrue to higher-rate taxpayers. It also does not include capital gains tax relief on capital gains made within pension funds; that is a big part of the relief on investment returns, but the government produces no estimate of it.
Finally, note that the government does not publish estimates of the cost of exempting bequeathed pension pots from inheritance tax ((iv) above). The cost of that will be small at the moment, as most of those now dying either have DB pensions or had already used their DC pension pot to buy an annuity before the introduction of ‘pension freedoms’ in 2015 removed the requirement to do so. But as this new and tax-advantaged option grows in popularity, its cost is likely to rise rapidly.