If you want to maximise your money, knowing how you make your pension contributions is important.
There are 3 main reasons you should be interested:
1. You could be due a tax refund dependent on your circumstances.
2. You’ll know where to make additional contributions if you have surplus income
3. You’re going to rely on your pension to support your expenditure one day, and maximising your contributions makes sense.
There are three primary methods of contributing to a pension: the Net Pay Method, Relief at Source, and Salary Sacrifice.
1. Net Pay Method
The ‘net pay method’ involves pension contributions being deducted from your gross salary before income tax is calculated. Your contributions reduce your taxable income, and you automatically receive tax relief at your highest marginal rate.
For example, if you earn £100,000 a year and contribute 5% (£5,0000) to your pension using the net pay method, your taxable income would be reduced to £95,000 for the income tax calculation.
The net pay method usually occurs in workplace pensions.
However, your income for the purposes of national insurance calculation remains at £100,000. The net pay method does not save national insurance contributions for the employee or the employer.
2. Relief at Source
Under the ‘relief at source’ method, pension contributions are made from your net (after-tax) pay, and your pension provider claims basic-rate tax relief (20%) on your behalf from HMRC.
For example, if you contribute £800 per month, your pension provider will claim an additional £200 from HMRC, making your total monthly contribution £1,000.
Your personal basic rate tax band expands by the total pension contributions made via the relief at source method. Higher and additional-rate taxpayers must claim extra tax relief through their self-assessment tax return.
This is how nearly all personal pension contributions are made. Some workplace pensions also use this method (particularly in small businesses).
3. Salary Sacrifice
Salary sacrifice, also known as salary exchange, involves an agreement with your employer to reduce your gross salary by an amount equivalent to your pension contributions. In return, your employer makes contributions to your pension on your behalf.
This method can be highly tax-efficient as it reduces both your income tax and national insurance contributions.
For instance, if you agree to a salary sacrifice of £2,000 per month, your gross salary is reduced by this amount, and your employer contributes £2,000 directly to your pension.
This is particularly advantageous for employees where employers decide to contribution all or part of their 13.8% national insurance contribution saving to your pension.
Summary
Here are the most important points to look out for
If your employer uses the net pay method, ask if they’d consider switching to salary sacrifice to save national insurance
If you’re a higher or additional rate taxpayer and contributing under the relief at source method, make sure you complete a tax return… correctly!
Prioritising contributions via your workplace pension rather than personal contributions will maximise your money if salary sacrificed is used by your employer.
You can find out how your pension contributions are made from information in your payslip and your pension contribution statement. Failing that, contact your HR team.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). Your capital is at risk. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested.
For those of you who want to make sure your pension is invested well, see if you’re on track to meet your goals and feel the peace of mind from a professional looking over your finances, we can help you. Book a call here.