How does tax relief work on pension contributions paid via payroll?

Pension tax relief is a way that the government uses the tax system to encourage employees to save for the future. With minimum auto enrolment pension contribution rates set to increase again from 6th April 2019, here is a useful guide for employees and employers to understand how tax relief works on pension contributions paid via payroll. There are 2 ways in which this works:

• By giving employees a top up on pension contributions that they make. This is called “relief at source”. NEST is one example of a pension scheme that uses this method. “Relief at source” works by applying only 80% of the full pension contribution rate to the amount to be deducted from the employee’s pay. For example, if the employee’s pension contribution rate is 3%, the rate that is actually applied to the payroll pension calculation is 2.4% (i.e. 80% of 3%). The remaining 20% of the employee’s pension contribution is topped up by HMRC who pay this direct to the pension scheme provider, to be added to the employee’s pension pot.
• By reducing the amount of tax that the employee pays via payroll. This is called “net pay arrangement”. Creative Pension Trust is one example of a pension scheme that uses this method. With a “net pay arrangement”, the employee pays the full pension contribution rate amount. For example, if the employee pension contribution rate is 3% then the rate that is actually applied is 3%. However, before tax is calculated in payroll, the pension contribution amount is first deducted from earnings thereby reducing the amount of taxable earnings and therefore the tax that the employee pays is less.

To show how these 2 methods work, let’s take the example of 2 employees working for 2 different employers. Both employees have the same tax code BR (i.e. all earnings taxed at 20%). Employee A’s employer uses a “relief at source” pension scheme and Employee B’s employer uses a “net pay arrangement” pension scheme. For a particular month, both employees have gross earnings of £2,000.00 and they are both set to make pension contributions at 3%. For the sake of simplicity, we will assume that pension contributions are made on total gross earnings.

Employee A
Pension contributions = £2,000.00 x 2.4% (i.e. 80% of 3%) = £48.00. HMRC top up the employee’s pension pot with the remaining 20% which is £12.00 (i.e. £2,000.00 x 0.6%). The employee ends up with £60.00 in their pension pot.
Tax at 20% = £2,000.00 x 20% = £400.00
Therefore, take home pay = £2,000.00 - £400.00 (tax) - £48.00 (pension) = £1,552.00

Employee B
Pension contributions = £2,000.00 x 3% = £60.00
Tax at 20% = £1,940.00 (i.e. £2,000.00 gross earnings less £60.00 pension contribution) x 20% = £388.00
Therefore, take home pay = £2,000.00 - £60.00 (pension) - £388.00 (tax) = £1,552.00

Comparing the two, we see that both employees end up with the same amount in their respective pension pots and the same take home pay: Employee A pays £48.00 via payroll and gets a top up of £12.00 from HMRC while Employee B pays £60 into the pension and pays £12.00 less tax as a result.

On the face of it, it might look like it doesn’t make a difference to employees if a pension scheme uses “relief at source” or “net pay arrangement”. However, for low earners who earn above the auto enrolment trigger (£10,000.00 per annum or £833.33 per month) but at or below the normal tax threshold (£11,850.00 per annum or £987.50 per month for 2018/19), a “relief at source” pension scheme is a better option than a “net pay arrangement” one.

As an example, let’s take 2 employees on £950.00 per month and same tax code of 1185L M1 (tax-free allowance of £987.50 per month). Again, we will assume that pension contributions are paid on all gross earnings.

For Employee A who is in a “relief at source” pension scheme, pension contributions via payroll would be £22.80 i.e. £950.00 x 2.4% (i.e. 80% of 3%) and £5.70 would be topped up by HMRC. Total amount in the employee’s pension pot would therefore be £28.50 (i.e. £22.80 plus £5.70). Because the earnings of £950 are below the tax-free allowance, the employee pays no tax and their take home pay is £927.20 (i.e. £950.00 - £22.80).

For Employee B who is in a “net pay arrangement” pension scheme, pension contributions would be £28.50 i.e. £950.00 x 3%. Since the earnings are below the tax-free allowance threshold anyway, there is no tax to pay. The take home pay however is £921.50 (i.e. £950.00 - £28.50), which is lower than that for Employee A.

Because of this anomaly between the 2 types of tax relief for low income earners, there are growing calls on the government to change the rules to make it fair for everyone.