This is Money analysis: Pension tax relief effectively rebates any tax you would have paid on your contributions, to put you back where you started.
It supports the long-standing principle of saving into a pension from untaxed earnings, which has been enjoyed by generations of workers.
Income from pension pots is then taxed when it is withdrawn in retirement.
Tax relief is also considered an important encouragement to get people to save into pensions.
This is something that has become more important as employers have shifted from defined benefit schemes, where they take responsibility for retirement income, to defined contribution schemes, where workers must build a pension pot and use it to fund retirement.
> How pensions work: Your essential guide to retirement saving
The tax relief top-up to pension pots is based on people’s income tax rates of 20 per cent, 40 per cent or 45 per cent.
Pension contributions typically get 25 per cent added automatically to take savers back to their pre-basic rate tax position: taking £80 contributed after tax back to the £100 earned before 20 per cent tax.
Higher earners can then claim back 40 per cent or 45 per cent tax on their contributions above those earnings thresholds.
This looks like it tilts the system in favour of the better paid, as they get more in tax relief. However, this is simply because they pay a higher rate of tax in the first place.
An alternative system is salary sacrifice workplace pensions, where workers gain all of the tax relief benefit as they swap their income for an additional amount paid into their pension by their employer pre-tax.
Freezing tax thresholds has dragged more workers into the higher rate 40p tax bracket, the 60 per cent tax trap as the personal allowance is removed above £100,000, and the 45p tax rate that now kicks in at £125,140.
This has pulled in more tax revenue for the government, but subsequently increased the cost of pension tax relief, as more is paid out at higher rates. The amount being made by the Treasury from this fiscal drag far outweighs the extra tax relief cost though.
Rachel Reeves is rumoured to be considering a raid on pension tax relief but this would be highly controversial and create extra generational unfairness – as younger workers lose the saving benefit older generations enjoyed.
It would also be highly complicated and cause issues for defined benefit schemes, much of which are now in the public sector, and salary sacrifice system pension schemes.
> How would flat rate tax pension relief affect salary sacrifice schemes?
