Providing a workplace pension scheme is a legal requirement for most employers. Good schemes can also be an effective way of recruiting and retaining staff, as they can help employees save for the future in a tax-efficient way.

There are three main methods by which employees making contributions to a workplace pension scheme can get tax relief, but the terminology can be confusing and lead employers to make mistakes when running the payroll. In this article, we’ll look at all three approaches, and highlight where mistakes can be made.

Relief at source

This is the default method of providing tax relief for all registered pension schemes set up since April 2006.

An employee’s pension contributions are made after tax and National Insurance contributions have been deducted from their gross pay. Basic rate tax relief is then claimed by the pension scheme administrator on the amount paid to the pension fund on behalf of the employee.

For instance, if an employee in England, Wales or Northern Ireland (Scottish tax rates differ) wants to add £100 to their pension fund, their employer would need to take £80 from their after-tax pay and pay it into their pension fund. The scheme administrator would then claim an additional £20 from HMRC as basic rate tax relief, giving a total of £100 added to the fund.

The term relief at source is potentially misleading, because only basic rate tax relief is given automatically. If the employee is a higher rate taxpayer, they can claim an additional £20 of tax relief (or £25 if they’re an additional rate taxpayer) by completing a Self-Assessment tax return, or by asking HMRC to adjust their PAYE code.

Net pay

Pension contributions under this system are deducted from gross pay, before tax and National Insurance Contributions (NICs) are calculated. The term net pay is therefore confusing, as it refers to the point at which tax is calculated rather than when pension contributions are deducted.

In this way, full tax relief is provided at source regardless of what rate of tax the employee pays, meaning no further tax relief needs to be claimed separately by higher or additional rate taxpayers.

For an employee wishing to add £100 to their pension fund under net pay arrangements, their employer needs to deduct £100 from the employee’s gross pay and transfer it to their pension fund. That £100 does not suffer tax, so full relief is given at the time of making the contribution, regardless of whether the employee is a basic, higher or additional rate taxpayer. Employers and Employees NIC is still payable on the sum, as NICs are calculated based on gross salary. 

Salary sacrifice

Under salary sacrifice arrangements, an employee doesn’t make any contributions to the pension scheme themselves. Instead, they agree to give up the right to an amount of their salary in return for their employer making extra contributions to the pension scheme on their behalf.

To achieve a £100 contribution into their pension fund under salary sacrifice, the employee would need to agree with their employer to give up the right to £100 of salary in exchange for a £100 pension contribution. The employer then pays £100 into the employee’s pension fund, along with their normal employer contributions. In this case, there is a tax saving and NIC saving, as no Employers or Employees NIC needs to be paid on the contribution.

Potential sources of error and how to resolve them

Errors can arise where employee pension contributions made under relief at source arrangements are incorrectly reported through RTI as net pay contributions. This results in tax relief being wrongly given through the payroll, in addition to the tax relief which the pension administrators will be claiming.

Employers who have made this error need to correct it as soon as possible, in most cases using HMRC’s digital disclosure facility. Large employers may have an HMRC Customer Compliance Manager who should be able to assist in putting right the underpayment.

Errors can also arise with salary sacrifice arrangements if the employer incorrectly classifies the amount of pension contributions made in return for salary foregone. If these amounts are reported through RTI as employee pension contributions, the pension scheme administrator will wrongly claim tax relief as if the amounts were made under relief at source arrangements.

Employers who have made this mistake will need to inform their scheme administrator as soon as the error is discovered, but the responsibility for correcting this type of error then rests with the pension administrator.

 

This article reflects the position at the date of publication (14 September 2023). If you are reading this at a later date you are advised to check that that position has not changed in the time since.   

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