Pension Types
There are two types of pension:
Salary Sacrifice (aka net pay arrangement) - this is paid into your pension before tax is deducted on your payslip.
Relief at Source (relief at source definition) - this is paid into your pension after tax is deducted on your payslip.
An example of both scenarios is given below showing what would happen if you were a 40% higher rate taxpayer:
Salary Sacrifice
Payslip:
£133 (Gross Salary) - £100 (Pension Contribution Before Tax) = £33 (Taxable Pay)
£33 (Taxable Pay) - £13 (40% Tax Deduction) = £20 (Received Personally)
Pension Pot:
£100 is received through salary sacrifice and so no tax is claimed back from the government.
Personal Tax:
There are no entries on your personal tax return.
Summary:
The outcome here is £100 in pension pot & £20 received personally.
Relief at Source (excluding the effects of national insurance)
Excluding the effects of national insurance.
Payslip:
£133 (Gross Salary) - £53 (40% Tax Deduction) = £80 (Net Pay)
£80 (Net Pay) - £80 (Pension Contribution After Tax) = £0 (Received Personally)
Pension Pot:
£80 is received through relief at source and so 20% basic rate tax is claimed back from the government by your pension provider. On an £80 contribution, £20 is given to ‘top up’ your pension pot.
£80 (Pension Contribution After Tax) + £20 (Basic Rate ‘Top Up’) = £100 (Pension Pot)
Personal Tax:
Your basic rate tax band is increased so that you can receive tax relief on your self-assessment tax return.
£80 (Pension Contribution After Tax) + £20 (Basic Rate ‘Top Up’) = £100 (Adjustment to Basic Rate Tax Band)
£100 is then taxed at 20% instead of 40% - so £100 x (0.4 - 0.2) = £20 Tax Refund Received Personally.
Summary:
The outcome here is exactly the same as the scenario above: £100 in pension pot & £20 received personally. However, this is excluding the effects of national insurance deductions - see below for the full picture.
Relief at Source (including the effects of national insurance)
Including the effects of national insurance.
Payslip:
£133 (Gross Salary) - £56 (40% Income Tax + 2% National Insurance Deduction) = £77 (Net Pay)
£77 (Net Pay) - £77 (Pension Contribution After Tax) = £0 (Received Personally)
Pension Pot:
£77 is received through relief at source and so 20% basic rate tax is claimed back from the government by your pension provider. On a £77 contribution, £19 is given to ‘top up’ your pension pot.
£77 (Pension Contribution After Tax) + £19 (Basic Rate ‘Top Up’) = £96 (Pension Pot)
Personal Tax:
Your basic rate tax band is increased so that you can receive tax relief on your self-assessment tax return.
£77 (Pension Contribution After Tax) + £19 (Basic Rate ‘Top Up’) = £96 (Adjustment to Basic Rate Tax Band)
£96 is then taxed at 20% instead of 40% - so £96 x (0.4 - 0.2) = £19 Tax Refund Received Personally.
Summary:
The outcome here is £96 in pension pot & £19 received personally.
Other Considerations
Salary Sacrifice (benefits):
More tax efficient (as you can see in the example above).
You don’t have to claim tax relief back from HMRC & tax relief is received instantly.
Reduces your salary which could have a positive effect on the child benefit you may receive.
As you are being paid less through PAYE your employer will pay less in employers national insurance.
Relief at Source (benefits):
Increases the amount shown on your P60 and so increases the amount you can borrow for mortgage purposes.
If you don’t pay any tax you can contribute up to £2,880/tax year and still claim 20% tax relief.
Other Considerations:
Both methods may have positive/negative effects on your working tax credits and maternity/paternity pay.