Pension Tax Relief Explained: How to Maximise Your Retirement Savings

How Pension Tax Relief Works

Pension tax relief is the government's way of incentivising retirement saving. When you contribute to a registered pension scheme, HM Revenue & Customs (HMRC) effectively refunds the income tax you paid on that money. The result is that your pension contributions come from pre-tax income, giving your retirement savings a significant boost.

The mechanism depends on the type of pension scheme you belong to. With relief at source schemes (including most personal pensions and SIPPs), you contribute from your net pay and the pension provider automatically claims basic rate tax relief (20%) from HMRC and adds it to your pot. If you contribute £800, your pension receives £1,000. Higher and additional rate taxpayers then reclaim the remaining relief — an extra 20% or 25% — through their self-assessment tax return.

With net pay arrangements (common in workplace defined benefit and some defined contribution schemes), contributions are deducted from your gross salary before income tax is calculated. This means you automatically receive full tax relief at your marginal rate without needing to make a separate claim.

It is essential to understand which method your scheme uses, because higher and additional rate taxpayers in relief at source schemes must actively claim their extra relief. HMRC estimates that hundreds of millions of pounds go unclaimed each year because taxpayers do not realise they are entitled to further relief beyond the basic 20%.

Annual Allowance: £60,000 for 2024/25

The annual allowance is the maximum amount of pension savings you can make each tax year with tax relief without incurring a tax charge. For the 2024/25 tax year, the standard annual allowance is £60,000. This was increased from £40,000 in the Spring Budget 2023 — a welcome boost after years of stagnation.

The annual allowance covers the total of all contributions to all your pension schemes, including your personal contributions, employer contributions, and any contributions made by third parties on your behalf. It also includes the value of any benefits accrued in defined benefit schemes, which is calculated using a specific formula based on the increase in your accrued pension multiplied by 16, plus any increase in your lump sum entitlement.

If you exceed the annual allowance, you will face an annual allowance charge. This charge effectively adds the excess contributions to your taxable income for the year, meaning you pay tax at your marginal rate on the overshoot. For high earners, this could mean a charge of up to 45% on the excess amount.

There is also a money purchase annual allowance (MPAA) of £10,000, which applies once you have flexibly accessed your defined contribution pension benefits. This significantly restricts the amount you can contribute to a money purchase pension with tax relief, so it is important to understand the trigger events before drawing on your pension pot.

Tapered Annual Allowance for High Earners

If you are a high earner, your annual allowance may be reduced through the taper mechanism. The taper applies when your adjusted income exceeds £260,000 (from 2023/24 onwards). Adjusted income includes your total taxable income plus the value of any employer pension contributions.

For every £2 of adjusted income above £260,000, your annual allowance is reduced by £1. This continues until the allowance reaches a floor of £10,000, which occurs at an adjusted income of £360,000. Additionally, the taper only applies if your "threshold income" — broadly, your taxable income excluding pension contributions — exceeds £200,000.

The interaction between these two tests is nuanced. Consider a company director with a salary of £210,000 and employer pension contributions of £55,000. Their threshold income is £210,000 (above £200,000) and their adjusted income is £265,000 (above £260,000). Their annual allowance would be reduced by £2,500 to £57,500. However, if they restructured their remuneration using salary sacrifice to bring their contractual salary below £200,000, the taper would not apply at all.

Carry Forward: Using Unused Allowance from Previous Years

Carry forward is one of the most valuable yet underused pension planning tools. It allows you to make use of any annual allowance that you did not use in the three previous tax years, effectively enabling pension contributions well in excess of £60,000 in a single year.

To use carry forward, you must first use your current year's annual allowance in full. Any excess contribution is then set against unused allowance from the earliest available year first (on a first-in, first-out basis). You must have been a member of a registered pension scheme in each of the years from which you wish to carry forward, although you do not need to have actually made contributions in those years.

There is one important constraint: your total pension contributions in any given year cannot exceed your relevant UK earnings for that year (or £3,600 if higher). So even if you have significant carry forward available, you need sufficient earnings to support the contribution.

Carry forward is particularly valuable for individuals who have received a bonus, sold a business, or had a windfall year and want to shelter a substantial sum from income tax. In theory, if you had not used any allowance for the previous three years and the current year, you could contribute up to £240,000 in a single tax year (4 x £60,000), subject to having sufficient earnings.

The Lifetime Allowance: Abolished and Replaced

The pension lifetime allowance (LTA) — which capped the total value of pension benefits you could accumulate tax-efficiently — was formally abolished on 6 April 2024. Previously set at £1,073,100, the LTA had been a source of significant concern for long-standing pension savers and those with generous defined benefit pensions.

The lump sum allowance of £268,275 limits the total amount of tax-free cash you can take from all your pensions during your lifetime. The lump sum and death benefit allowance of £1,073,100 is a broader cap covering tax-free lump sums, serious ill-health lump sums, and certain death benefit lump sums paid before age 75.

The abolition of the LTA is excellent news for those with substantial pension pots. There is no longer a punitive tax charge on pension savings above a fixed threshold. However, the new lump sum limits mean that the amount you can take as tax-free cash is still restricted. Any withdrawals above these limits will be taxed as income at your marginal rate.

Tax-Free Lump Sum: 25% Up to £268,275

One of the most attractive features of pensions is the ability to take 25% of your pension pot as a tax-free lump sum (often called the pension commencement lump sum or PCLS). Since April 2024, this is subject to the new lump sum allowance of £268,275 across all your pension schemes.

For most people, this means a pension pot of up to approximately £1,073,100 can generate the maximum tax-free cash of £268,275. Above that level, the 25% tax-free proportion no longer fully applies — the excess must be taken as taxable income or left invested in the pension. Those with LTA protections registered before the abolition may have higher limits, which is an important reason to preserve any existing protections.

There is no requirement to take all the tax-free cash at once. Under flexi-access drawdown, you can take the 25% tax-free element in tranches over time, which can be useful for managing your income tax liability in retirement.

Pension Tax Relief for Different Earners

The value of pension tax relief increases with your marginal tax rate, making pensions especially powerful for higher earners.

For those caught in the £100,000 to £125,140 income range, pension contributions are even more valuable. The personal allowance is withdrawn at a rate of £1 for every £2 of income above £100,000, creating an effective marginal tax rate of 60%. A pension contribution that brings your adjusted net income below £100,000 restores your personal allowance, delivering an effective 60% rate of tax relief on that contribution. This makes pension contributions the single most effective tax planning tool for individuals in this income band.

Salary Sacrifice for Pension Contributions

Salary sacrifice (sometimes called salary exchange) is an arrangement where you agree to reduce your contractual salary, and in return your employer pays the equivalent amount into your pension. The key advantage is that both employer and employee National Insurance contributions (NICs) are saved on the sacrificed amount.

For the 2024/25 tax year, employee NICs are charged at 8% on earnings between £12,570 and £50,270 (with 2% above that threshold). Employer NICs are charged at 13.8% above £9,100. When you sacrifice salary into a pension, these NICs are eliminated entirely on the sacrificed amount. Many employers pass on some or all of their NIC saving as an additional pension contribution, making the arrangement even more attractive.

However, there are important considerations. Salary sacrifice reduces your contractual salary, which can affect your entitlement to statutory maternity pay, statutory sick pay, and mortgage borrowing capacity. Your employer must ensure that your post-sacrifice salary does not fall below the National Minimum Wage. It is also worth noting that salary sacrifice arrangements must be genuine — they need to be agreed in advance and cannot be applied retrospectively.

Pensions and Inheritance Tax

One of the most powerful but often overlooked features of pensions is their treatment for inheritance tax (IHT) purposes. Defined contribution pension pots generally sit outside your estate for IHT and are therefore not subject to the 40% inheritance tax charge that applies to most other assets above the nil-rate band.

Under the current rules, if you die before age 75, your nominated beneficiaries can inherit your pension pot entirely free of income tax and IHT, provided it is paid within two years. If you die after age 75, beneficiaries will pay income tax at their marginal rate on any withdrawals, but the pot itself remains outside your estate for IHT purposes.

This makes pensions a remarkably effective estate planning tool. A common strategy is to draw down other savings and investments during retirement — paying income tax along the way — while leaving the pension pot untouched for as long as possible. The pension pot then passes to the next generation free from IHT, and potentially free from income tax if the pension holder dies before 75.

For asset-rich individuals who are also concerned about their inheritance tax exposure, coordinating pension planning with broader inheritance tax strategies is essential. Tools such as family investment companies can complement pension arrangements by providing additional avenues for tax-efficient wealth transfer.

Common Pension Tax Mistakes to Avoid

Even experienced taxpayers can fall foul of pension tax rules. Here are the most common mistakes we see:

1. Failing to claim higher rate relief. If you pay into a relief at source pension, the provider only claims 20%. Higher and additional rate taxpayers must claim the rest through self-assessment. HMRC estimates billions go unclaimed.
2. Ignoring the money purchase annual allowance. Once you flexibly access a defined contribution pension (beyond the 25% tax-free cash), your annual allowance for money purchase pensions drops to just £10,000. Taking even a small amount of taxable income from your pot triggers this.
3. Overlooking the tapered annual allowance. High earners often forget that employer contributions count towards adjusted income. A pay rise or bonus can push you into the taper without warning.
4. Not using carry forward. Many people assume they can only contribute £60,000 per year. If you have unused allowance from the past three years, you could contribute significantly more.
5. Forgetting to nominate beneficiaries. Pension death benefits are paid at the discretion of the scheme trustees, guided by your expression of wish form. Failing to keep this updated — especially after a divorce or new relationship — can lead to your pension going to the wrong person.
6. Drawing a pension too early and triggering the MPAA. Some people access their pension pot for short-term cash needs without realising the long-term impact on their contribution capacity. If you are cash-poor but asset-rich, there may be better ways to access liquidity.
7. Not considering the impact on means-tested benefits. Pension income counts as income for the purposes of tax credits, universal credit, and other means-tested benefits. Withdrawing large sums in a single tax year can have unintended consequences.