How does pension tax relief work?

Despite all the restrictions and rule changes over the years, pensions still arguably offer one of the most generous sets of tax relief available.

You could get up to 45% tax relief when you contribute, tax-free growth whilst your money is invested and up to 25% tax-free cash when you take money out. 

Please note: this article gives a very concise overview of complex rules and doesn’t cover all scenarios or exceptions – for example, it does not cover the tax relief position in Scotland, nor the rules for defined benefit pensions. If you are unsure how the rules may apply to you, please seek specialist advice. Tax rules can change and benefits depend on circumstances.

For most investors under age 75, when you make a payment of £8,000 to a pension, the government automatically adds £2,000 (20%). In addition, if you are a higher or top-rate taxpayer you can claim back up to an extra 20% or 25% respectively. The higher the rate of tax you pay, the more tax relief you could receive.

As a result, a £10,000 contribution could effectively cost a higher-rate taxpayer as little as £6,000, reducing to £5,500 for a top-rate taxpayer.

Remember: tax rules can change and benefits depend on circumstances.

Most UK residents under age 75 with an earned income should be able to benefit in some measure. As a rule of thumb (although there are exceptions), this tax year it is possible to contribute as much as you earn, capped at £60,000 – and receive up to £27,000 tax relief.

There are situations when the maximum you can contribute is lower – and consequently so is the tax relief you could receive.

1. Non-earners and non-taxpayers

You can make a payment of up to £2,880 each tax year, to which the government adds £720, to give a total SIPP contribution of £3,600.

2. Investors who have already taken cash from a pension using the pension freedoms

If you have taken cash from a pension (in one go or as smaller lump sums), the annual allowance is generally £10,000. This is called the ‘Money Purchase Annual Allowance' (MPAA). Once your annual allowance is reduced to £10,000, you won’t be able to carry forward any unused allowances from previous tax years. Download our Factsheet on the Money Purchase Annual Allowance »

3. Some higher earners

You may not be able to use the full £60,000 annual allowance and potentially be restricted to contributing as little as £10,000 a year.

This might affect people whose ‘adjusted income’ in the tax year exceeds £260,000.

Broadly speaking, adjusted income is any income – from employment, property, investments, etc – PLUS any employer pension contributions and those deducted from your gross pay LESS any taxed lump sums or death benefits.

If you are affected, your annual allowance for the tax year reduces by £1 for every £2 of adjusted income above £260,000. This is called the ‘tapered annual allowance’. If you have an adjusted income of £360,000 or more you will have an annual allowance of £10,000. Download our Factsheet on the Tapered Annual Allowance »

You should, however, be able to carry forward if you have any unused allowance from previous years. Download our Factsheet on Pension Carry Forward »

The rules around the tapered annual allowance are complex and this is only a summary. You can read more on the HMRC website. If in doubt, please seek specialist advice.

The Lifetime Allowance previously set the limit of total value that could be built up in pensions without incurring a tax charge. It has been abolished from 6 April 2024.

In theory, this means there are no longer limits on how large a pension you can build. However, in practice, the rules are not as straightforward for those wishing – and able to – build a large pension, as new rules have been introduced, limiting the total amount of tax-free cash you can take in your lifetime and you can pass on when you die.

A new Lump Sum Allowance (LSA), effective from 6 April 2024, limits the tax-free cash you can get from your pension to £268,275.

Meanwhile, a second new allowance, the Lump Sum and Death Benefit Allowance (LSDBA) – also effective from 6 April 2024 – limits the total amount of tax-free cash you can take in your lifetime and you can pass on when you die to £1,073,100, in most cases. 

So, if you build a large pension, a greater proportion may be taxed when you take the money out, making pensions progressively less tax efficient, the larger the pot you build. Different limits may apply if you have previously applied for Lifetime Allowance Protection (you should have a certificate from HMRC to this effect or can check via your online HMRC account). If you have protection, it could be sensible to take advice before making any decisions that could impact it.

Currently, pensions wouldn’t normally form part of your estate. This means their value doesn't use up your IHT-free allowance ("nil-rate band", currently £325,000 per individual) and your beneficiaries don't have to pay IHT. 

This is changing. From 6 April 2027, the government will bring most unused pension funds and death benefits into scope of IHT (standard rate of 40%).