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With many of us likely to need means beyond the State Pension for our later years, considering personal pensions – and the tax relief on offer – could help you get one step closer to your dream retirement.

We all know that a pension can help to fund our retirement. However, many of us aren’t as aware of how tax relief can increase the total contribution to our pension pot.

Our research shows that almost half of UK adults are planning to use the State Pension to fund their retirement. However, the amount it pays arguably falls far short of covering even the most basic lifestyle for the average person when they retire. So, it’s important to build up your own retirement savings.

Our survey, of 2,000 UK adults, also found that more than a third (38%) of people questioned said they had never heard of pension tax relief, with just 8% saying they know a lot about how it works.

If you are in the category of wanting to learn more, here we’ll explain how tax relief can help to boost your workplace or personal pension funds as well as other tax-efficient investment options, like ISAs.

What is pension tax relief?

As an incentive for us to invest for our retirement, the Government allows for a level of tax efficiency on pensions. When you pay into your pension, some of the money that would have been taxed goes into your pension instead. 

To be exact, if you’re a basic rate taxpayer, contributions you make to your workplace or personal pension benefit from 20% tax relief. This means that every pound in your pension only costs you 80 pence, with the other 20p coming from the basic rate of income tax you would have paid. Instead of HMRC receiving that tax, it goes straight into your pension pot.

Basic rate tax relief is either paid into your pension at source with pension providers, such as Nutmeg, automatically adding the 20% to your pot, or through a net pay arrangement whereby it is applied later. 

If you are out of work or earn less than the personal allowance (£12,570 in the tax year 2023/24), you may not get tax relief on contributions to a workplace pension – ask your employer, or whoever administers the scheme, if this is applicable.

The limit on how much you and your employer can contribute to a pension each year while benefiting from this tax relief is £60,000 or 100% of your annual salary, whichever is lower. However, this amount is subject to tapering if you’re a very high earner.

Tax relief is linked to the highest band of income tax you pay and you may claim back tax relief over the 20% basic rate from HMRC. This means that if you’re a higher-rate or an additional-rate taxpayer you could get up to 40% or 45% tax relief respectively. For example, a £10,000 pension payment could cost you just £6,000 if you’re a higher-rate taxpayer or £5,500 as an additional-rate taxpayer.

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Pension tax relief compared with ISAs

There’s a clear difference between tax relief on pensions and how tax-efficiency works with ISAs, which may be another way of investing for your retirement.

For pensions, tax relief effectively means you don't pay income tax on the money you contribute to your pension pot. Then, although you can withdraw a tax-free lump sum of up to 25% from your pension after age 55 (rising to 57 from 2028), you may pay income tax on withdrawals above the 25%. 

The difference with an ISA is that you may have already paid income tax on the money you contribute and any withdrawals are not taxed.

It can be easier to think of it as: with ISAs your money may have been subject to tax on the way in. With pensions your money may be subject to tax on the way out. Both ISAs and pensions offer tax efficiency on the journey.

Another big difference between the two is the annual contribution allowance. As discussed above, for pensions it’s up to £60,000 or 100% of your annual salary, whichever is lower, whereas for ISAs it is capped at £20,000.

Lifetime ISA

For those eligible, a Lifetime ISA (LISA) can be a beneficial option to invest for retirement. A LISA can be opened by those aged 18 or over with the first contribution having to be made before you turn 40. The aim of the LISA is for the money to go towards buying your first home or for retirement (from the age of 60).

The annual limit on contributions is £4,000 but you should note that this counts towards your overall £20,000 ISA allowance.

A major benefit of a LISA is that the government will add a 25% bonus to your annual contribution up to a maximum of £1,000 per year. You can make contributions to your LISA until you turn 50, after which you can still benefit from interest or any potential investment returns on your investments.

Note that penalties can apply if you access the money in your LISA before you turn 60 where it is not for the purpose of buying your first home (up to the value of £450,000).

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The right decisions today for your financial future

For most of us, a pension will be a long-term investment over several decades. It makes sense then that tax relief can make a huge difference to your retirement pot over a long timeframe.

Still, with the various types of pensions and investment options available, it can feel overwhelming to decide what’s right for you.

Should you, for example, consolidate and transfer your pensions into one account? This may make things easier if you can see your total retirement savings in one place, while also giving you greater control in setting your level of investment risk.

What about ISAs and other investment products? Where is the most efficient place to save and invest your money that works in step with when you need it?

At Nutmeg, our experts can help you navigate through the issues you may want to consider when it comes to retirement planning as well as providing restricted advice about pension provision.

If you have questions about pensions or planning for your retirement, you can book a free call with a member of our team to discuss your retirement options.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. The above does not constitute tax advice or recommendations. Tax treatment depends on your individual circumstances and may be subject to change in the future.

A pension may not be right for everyone and tax rules may change in the future. Please note that during any transfer, your investments will be out of the market. If you are unsure if a pension is right for you, please seek financial advice. 

Source: Based on a survey of 2,000 UK adults carried out between 27-30 June 2023. Research carried out by Opinium.