This is Money’s analysis: Pension tax relief effectively refunds any tax you have paid on your contributions, putting you back on track.
It supports the traditional principle of saving for a pension from untaxed income, which has been enjoyed by generations of workers.
Income from pension funds is taxed when withdrawn during retirement.
Tax relief is also seen as an important incentive for people to save for pensions.
This is something that has become more important as employers have moved from defined benefit schemes, where they take responsibility for retirement income, to defined contribution schemes, where workers must build up a pension pot and use it to fund retirement.
> How Pensions Work: Your Essential Guide to Saving for Retirement
The tax relief applied to pension funds is based on personal income tax rates, which are 20%, 40% or 45%.
Pension contributions are usually automatically topped up by 25 per cent to return savers to their pre-basic rate tax position – the £80 contributed after tax is added to the £10 earned before 20 per cent tax.
Higher earners can then claim 40 or 45 percent tax on their contributions above those income thresholds.
This seems to tilt the system in favour of those with higher wages, as they get higher tax benefits. However, this is simply because they pay a higher tax rate in the first place.
An alternative system is salary sacrifice pensions, where workers get all the tax relief benefits by exchanging their earnings for an additional amount paid into their pension by their employer before tax.
The freeze in tax thresholds has pushed more workers into the top 40 per cent tax bracket, into the 60 per cent tax trap as the personal allowance is phased out above £100,000, and into the 45 per cent tax rate which now kicks in at £125,140.
This has generated more tax revenue for the government, but has subsequently increased the cost of pension tax relief as more are paid at higher rates. However, the amount the Treasury gets from this tax burden far exceeds the additional cost of the tax relief.
Rachel Reeves is rumoured to be considering a crackdown on pension tax relief, but this would be highly controversial and create further generational injustice as younger workers would lose the savings benefit enjoyed by older generations.
It would also be extremely complicated and would cause problems for defined benefit schemes, many of which are currently in the public sector, and for pension schemes with salary sacrifice systems.
> How would flat-rate pension tax relief affect salary sacrifice plans?
