How Do Pensions Work and What Tax Relief is Available

Planning for retirement is one of the most important steps any individual can take. Yet, the majority of us still underestimate how essential pension saving is, or how generous the tax incentives can be.

Whether you are an employee, a business owner, or self-employed, making regular pension contributions WILL transform your financial security later in life.  And understanding the UK’s pension system, the rules on contributions, and the available tax reliefs available will help you to achieve this.

This article briefly explains how pensions work, the main types of schemes available, and the tax advantages that accompany them.

What are the Different Types of Pension Contributions?

Although pensions come in many forms they all share the same purpose: to help you save throughout your working life so you can draw an income later in retirement.

You can either make personal pension contributions yourself, or an employer can also potentially pay into a personal pension on your behalf.

When you are “self-employed” pension contributions are also treated as personal pension contributions because you are NOT an “employee” of your business.  Likewise, these contributions cannot unfortunately be treated as a business expense.

When you are “employed” contributions typically take two forms:

• “Employee” or “Salary Sacrifice” contributions which are shown on your pay-slip as being deducted from your salary.
• Employer contributions which are additional pension contributions made directly by your employer into the scheme (and therefore do not form part of your salary).

What is Auto Enrollment and How Does This Work?

Historically companies were not legally obliged to make pension contributions on behalf of their staff.  However, Auto-Enrollment started in 2012, and now all employers must offer a workplace pension scheme and automatically enroll eligible workers within this.

If you are an employee your employer must therefore enroll you in a workplace pension if you meet the following conditions:

• You work in the UK
• You aren’t already in a workplace pension scheme
• You are at least 22 years old, but under State Pension age
• You earn more than £10,000 a year (for the 2025/26 tax year)

The minimum required contributions include: 5% from you (this percentage includes tax relief), and 3% from your employer.  The minimum contribution applies to “qualifying earnings”, which is anything you earn over £6,240 up to a limit of £50,270 (for the 2025/26 tax year)

You can opt out of your employer’s workplace pension scheme after you’ve been enrolled, but if you do, you’ll lose out on your employer’s contribution to your pension, as well as the government’s contribution in the form of tax relief.  So, this is definitely NOT advisable!

Although, you can re-join your employer’s workplace pension scheme at a later date if you want to.  In addition, your employer must automatically re-enroll you back into the scheme every three years.

How Much Can I Pay into My Pension?

There is actually no limit to the amount you can contribute into a pension each year.  However, there are definitely limits to the amount of pension contributions that qualify for tax relief!  And these limits apply to you as an individual regardless of the number of pension schemes that you have.

Tax relief on “personal” pension contributions is limited to the higher of: £3,600, or 100% of “Relevant UK Earnings”.  Although please note that while relevant UK earnings includes most forms of income, it specifically excludes: pension income, investment income, buy to let income, and dividends.  So, if you own a limited company and receive a high value of income as dividends, or you earn income from property, then this income cannot be included for making tax free pension contributions.

And tax relief is only available in the tax year in which the contributions are made.

What is the Annual Allowance?

In addition to the restrictions outlined above for “personal” pension contributions, there is also a total annual limit which can be paid into a pension each tax year (and receive tax relief) called the “Annual Allowance”.  The total annual allowance is currently £60k.

This limit applies to all contributions irrespective of source, e.g.:

• personal contributions,
• self-employed contributions,
• company/employer contributions, and
• contributions from anyone else (e.g. family) – Although please note that contributions received from third parties are treated as personal pension contributions and subject to the same limits outlined above.

And for very high earners (taxable income more than £260k), the £60k annual allowance is reduced by £1 for every £2 earned above this £260k limit, until it reaches £10k.

Given that the annual allowance increased from £40k to £60k in April 2023, with the exception of high earners, most people rarely use their full annual allowance each year.

In these cases (where you contributed less than £60k in pension contributions in a tax year), then you can carry forward any unused amount for up to 3 years.  Which is very useful where your business is far more profitable in some years than others!

How Much Can Your Employer Contribute to your Pension?

Employer contributions are NOT restricted by “relevant UK earnings” in the same way that personal pension contributions are, but they are subject to the same £60k tax free annual allowance.

For tax purposes, employer contributions are also normally allowable as a business expense.  Although, HMRC may challenge excessively high contributions made solely to reduce tax, so the contributions should be justifiable by reference to the employee’s role and level of pay.

For company directors, employer contributions can therefore be an extremely efficient way of extracting money from the company.

How is Tax Relief Obtained?

Pensions have been designed so that you pay tax when it is received (normally when you retire), instead of when the income is contributed to the scheme.  And the Government therefore provide “tax relief” on pension contributions.

Tax relief is obtained in different ways depending on who made the contributions and whether or not you are a higher rate taxpayer:

• Personal Pension Contributions – Where you have made the contributions yourself, referred to as “paying the NET value”, then the Government adds an extra 25% to the scheme. So as an example, if you contribute £4k as a personal pension contribution then the Government will pay an extra £1k into the scheme!
• Employee Pension Contributions – There are typically two types:
  • Relief at Source – These operate the same as Personal Pension Contributions. You pay the NET value after tax and the Government add the additional 25%.
  • Net Pay Arrangements – Similar to Employer Pension Contributions (discussed below) you make contributions into a pension scheme GROSS (including basic rate tax) before tax via your PAYE salary, then your salary is reduced by the value of these contributions, so you receive tax relief by paying less PAYE and NIC (instead of the Government adding an extra 25%).
• Employer Pension Contributions – Employers pay their contributions into a pension scheme GROSS (including basic rate tax) and they receive corporation tax relief by deducting the pension contribution as a business expense reducing Corporation Tax (instead of the Government adding an extra 25%).

For taxpayers who pay higher rate or additional rate tax (at 40% or more) it is also possible to obtain additional tax relief by submitting a self-assessment personal tax return, and then HMRC will also refund some of the tax you have already paid.

An additionally overlooked but significant taxation benefit is also the fact that all investment returns within your pension (including interest, dividends, and capital gains) are also free of UK income tax and capital gains tax.  And similar to ISAs, this makes pensions one of the most tax-efficient saving vehicles available!

When Do I Need to Start Making Contributions?

The droll answer to this is “yesterday”!  But in all seriousness, you cannot start making pension contributions too early because pensions grow over time through compound investment returns.

Small regular contributions made early in life often outperform large contributions made later on.

Delaying pension savings therefore risks missing years of tax relief and growth, and makes it much harder to build a sufficient fund later in life.

Should I Increase the Value of My Contributions as I Get Older?

While starting early is best, it is equally important to also review and increase your contributions over time, especially as your earnings rise or your financial circumstances improve.

Some people may also find that as they get quite a bit older that some of their financial commitments reduce (e.g. due to: mortgage repayment, more financially independent children, etc), allowing them to naturally make larger contributions.

How Big a Pension Do I Require?

There is no “correct” answer to this question as it definitely depends on the individual and the lifestyle you have become accustomed to and believe you will require.

But a simpler way to think of it is to say: What percentage of my existing annual salary will I need when I retire?  Often it is suggested to aim for around two-thirds (60–70%) of your working salary.

So as a very rough example:

• If you earn £45k a year before retirement
• You may want an income in the region of £30k a year in retirement
• You expect to receive the full State Pension (of circa £11.5k in 2025/26)
• That leaves a shortfall of £18.5k per year to be funded by your pension
• Assuming a drawdown of 4% of your pension each year (e.g. if you are retired for 25 years)
• That implies you would require a pension pot of circa £462.5k (£18.5k/0.04), or effectively £450,000 in today’s money!

Given that this must also support any tax-free lump sum withdrawals, potential future care costs, and inflation-adjusted spending, it is also advisable to always overestimate your needs.

Conclusions

As the above example illustrates, a very large pension pot is required to fund a relatively modest salary over longer (but not unrealistic) periods of time.  And irrespective of what you earn, you will almost always need more than expect when you retire.

So, it is worth restating why regular pension saving is essential for everyone!:

• State Pension Limitations: It is difficult or impossible to sustain a comfortable lifestyle funded by the State Pension alone.
• Rising Life Expectancies: Retirement can now easily last for 25 to 30 years, which significantly increases the size of the fund required.
• Tax Advantages: No other commonly available investment vehicle offers upfront tax relief, tax-free growth, and partial tax-free withdrawal.
• Compound Growth: Regular contributions invested over decades can multiply dramatically due to compound returns.
• Employer Support: Employers are required by law to make minimum contributions. So, opting out is like turning down free money!
• Inheritance Planning: Pension funds (currently) fall outside your estate for inheritance tax, allowing remaining funds to be passed to beneficiaries tax-efficiently. However, the current Labour Government has recently changed this, and from April 6, 2027 pensions will be treated as part of your estate as subject to Inheritance Tax.

Pensions remain one of the most powerful tools available for building long-term financial security and reducing your tax burden at the same time. Whether you’re employed, self-employed, or running a company, the principles are the same:

• Contribute regularly.
• Take advantage of generous tax reliefs.
• Review your plan annually.
• Increase contributions as your income grows.

Can QAccounting Help Me?

Yes, we aim to be the UK’s Premier Online Accountancy and Tax Accountant, and we are here to help you every step of the way, whether you need to understand the rules in greater detail or need advice about next best steps.

Please give us a call (0116 243 7868), email us, or contact us ONLINE to speak to a member of our Accounting team without delay!

Author: George Ian Hope BAcc(Hons), MSc(IT), FCCA, CGA, CPA

Managing Director – QAccounting Limited (www.qaccounting.com )

https://www.linkedin.com/in/gihope

Ian is a general practicing member of the Association of Chartered Certified Accountants with fellowship status (FCCA). He is also a member of the Certified General Accountants Association of Canada (CGA), and a member of Chartered Professional Accountants of Canada (CPA).

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