Senior staff at our firm were asked to take pay cuts of up to 20 per cent. Mine took me back into the basic rate income tax bracket.
What happens to my pension contributions on which I was benefiting from higher rate relief?
Pension impact: I took a pay cut and I’m back to paying basic rate income tax
Tanya Jefferies, of This is Money, replies: Many employers have asked staff to take pay cuts to help them withstand the financial impact of the Covid-19 crisis.
For some, this could see take home pay duck back under the £50,000 a year barrier – this is the threshold income that makes you a higher-rate tax payer.
This has a knock-on effect on pension contributions, so it is sensible to plan ahead in terms of the impact on your retirement savings and how you might mitigate this now and in future.
Individuals will be affected in different ways according to how their employer runs its pension scheme.
You might be on salary sacrifice – where contributions are foregone from a salary and paid directly in and so not taxed – or your employer might operate either a net pay or relief at source system, which we explain in the box below.
We asked a pensions expert at a specialist financial consultancy to explain in more detail how pension tax relief works and what action you could take.
Patrick Bloomfield, partner at pensions consultant Hymans Robertson, replies: Pensions get great tax breaks. That’s one of the reasons they’re such a good way to save.
Pension contributions are exempt from tax. This means your contributions come out of your pay before any income tax is charged. So £1 invested costs you less then £1 in take-home pay.
Patrick Bloomfield: ‘Pensions get great tax breaks’
Pensions also get mostly tax-free investment returns.
And you can take 25 per cent of you pension pot as a tax-free lump sum when you retire, with the other 75 per cent taxed as income when you take it.
The same amount of money goes into your pension scheme regardless of which tax bracket you’re in.
What changes is how much of your take-home-pay it costs you.
If you’re a basic rate tax payer, then £1 is invested in your pension pot costs you 80p of take-home pay (because basic rate tax is 20 per cent).
And if you’re a higher rate tax payer then that £1 costs you 60p of take-home pay (because higher rate tax if 40 per cent).
Pension tax relief looks at your pay and contributions across the whole year and gives you tax relief at your highest marginal rate.
So, if you’ve been a higher rate tax payer across the year then you’ll get higher rate tax relief on your pension contributions.
The important point is that your tax band doesn’t have any effect on how much is paid into your pension pot.
If you usually need to complete self-assessment to reclaim your pension tax relief then you’ll need to do that this year too.
If you don’t usually do self-assessment, then the tax relief automatically sorted itself out and you won’t need to do anything. Ask your employer or pension scheme if you’re not sure.
If your pay is reduced it’s probably going to reduce your pension contributions too. This is because most pension contributions are set as a percentage of your pay.
Investments have also been hit since Covid-19, although there has been a ‘bounce back’ in recent weeks.
There’s a few things you can do if you’re worried about whether you’re on track for a decent retirement. The first thing to do is get a handle on what savings you’ve already got.
Most pension providers have online tools that show you how much your pension pot is worth, how it’s invested and how much you’re paying into it.
You can also get an estimate of your likely state pension online here.
Net pay and relief at source
Employers and their pension providers have two options when handling pension tax relief for staff, writes This is Money.
Net pay means workers contribute directly into their pension before their tax bill is calculated, so their pension tax relief is already included and there is no need to claim it from HMRC.
Under relief at source the pension provider claims the income tax relief directly from HMRC and adds it to each worker’s pension.
This is Money’s pension columnist Steve Webb explains in more detail here.
Then you can look at the income your pension pots are likely to provide when you retire.
Most providers’ online tools also have modellers which you can use to get an estimate. Some also have handy tools that help you figure out how much income you’ll need, by asking you about your lifestyle and outgoings.
If it looks like you’re not on track for enough income in retirement I suggest you do the following:
1. Check you’re making the most of your employer’s pension contributions. Lots of employers match your contributions in some way, so make sure your you’re paying enough to get the most you can.
2. Think about increasing your contributions. I know it’s easy to say and hard to do, but even small changes make a difference over the years. The sooner you start the easier it is.
3. Be realistic about when you’ll retire. Most of us will live to well into our 80s or 90s. Your pension pot will go a lot further if you don’t start drawing it until you’ve reached your state pension age.
And whatever you do, don’t get scammed. Be wary of ‘free advice’ and ‘pension unlocking’. If you need help, speak to your employer or a Financial Conduct Authority-registered independent financial adviser who specialises in pensions.