I have had some questions regarding the calculation of relief for pensions contributions which are paid “net of tax”.
The Low Incomes Tax Reform Group (LITRG) have produced a short guide with basic information on pensions and pension schemes . You don’t need to know everything in there for examination purposes (but it would be worth reading once you’ve graduated.)
However I would recommend the section which addresses the question “What tax relief do I get on pension contributions?” It includes a worked example to show how relief is given to higher rate taxpayers.
Their example is based on a pension contribution of £50 a month which is equivalent to £600 a year (£50 x 12).
The £600 is treated as being net of basic rate tax.
The taxpayer’s pension scheme is credited with £750 being the £600 which the taxpayer has paid directly and an additional £150 which the pension company claims from HMRC. The £150 represents the basic rate tax on the gross value of the contributions. (£750 x 20% = £150).
If the contributor pays tax at the basic rate then these arrangments means they have received full tax relief without needing to complete a tax return or have their PAYE code adjusted.
However, if a taxpayer pays tax at the higher or additional rates, they are entitled to further tax relief.
We give this relief by extending the basic rate band (and if need be the higher rate band) by the grossed up value of their actual pension contributions. The quickest way of calculating this is usually to use the formula:
Net contributions x 100%/(100% – basic rate of tax )
= Net contributions x 100%/(100% – 20%)
= Net contributions x 100%/80%
= Net contributions x 100/80
In this case,
£600 x 100/80 = £750.