A reminder of how higher rate tax relief is applied and how, in some cases, the total tax relief can be more than 40%
Tax relief on personal pension contributions is limited to a maximum of 100% of the individual’s relevant UK earnings in the tax year the contributions are paid (and a minimum of £3,600). Essentially, this means the money the client has earned from their employment or the taxable profits from their self-employment.
Key investment income sources such as rental profits (other than those from qualifying furnished holiday lets), dividend income or savings income are excluded. However, this doesn’t mean that higher rate tax relief is not available on these types of income. This is because of the way in which the tax relief is applied.
With a relief at source scheme, the contribution is paid net and the provider will add the basic rate tax relief and reclaim this from HMRC. The individual’s basic rate tax band is then extended by the gross value of the pension contribution. This means the income that would otherwise fall into the higher rate tax band may now fall into the basic rate tax band. It doesn’t matter what form of income that is, i.e. the tax relief can be obtained against earned income, rental profits, savings income or dividend income. Where it is the latter, the rate of tax relief is higher than 40%.
A client has £12,000 of earnings and also receives £60,000 of dividend income. The maximum tax relievable personal contribution they could make is limited to £12,000 in the tax year. They pay the pension provider £9,600 net and the provider adds the £2,400 of tax relief.
The client’s basic rate tax band is then extended by £12,000 from £37,700 to £49,700. This means that £12,000 more of the dividend income is now taxed at the basic dividend rate of 8.75%, rather than the higher rate of 33.75% – a 25% saving or £3,000. This means the total tax relief is 45% (£2,400 + £3,000 = £5,400. £5,400/£12,000 = 45%).
Where individuals make contributions to a net pay scheme, i.e. an occupational scheme, the rate of tax relief is, currently*, exactly the same (aside from the anomaly for those with total taxable income below the personal allowance) as the taxable income is reduced by the gross contribution.
Note that although the dividend tax rates are reducing from tax year 2023/24, the tax saving in this example will still be the same as the rate will reduce down from 32.5% to 7.5%, i.e. 25%. And, although the basic rate of income tax is set to reduce to 19% from 6 April 2023, there will be a one-year transitional period for Relief at Source (RAS) pension schemes to permit them to continue to claim tax relief at 20%. Individuals can only receive higher rate tax relief to the extent they would otherwise have paid higher rate tax if they hadn’t made the pension contribution. For example, someone with taxable income of £60,270 and a full personal allowance, could only benefit from higher rate tax relief on contributions of up to £10,000. Any further contributions would only benefit from basic rate tax relief. (£60,270 – £37,700 basic rate tax band – £12,570 personal allowance = £10,000 in the higher rate tax band.)
It is also important that higher rate tax payers in relief at source schemes ensure they make a claim for the higher rate tax relief they are entitled to either on their self-assessment tax return, or if they do not fill in a self-assessment tax return, they can call or write to HMRC to claim.
*The basic rate of income tax is set to reduce to 19% from 6 April 2023. Where individuals make contributions to a net pay scheme, i.e. an occupational scheme, from 6 April 2023, the rate of basic rate relief they will receive will be at 19%.