Pension tax relief: net pay vs relief at source

Pension contributions get tax relief in one of two ways. Under a net pay arrangement, used by the NHS, teachers’, local government and Civil Service schemes, your contribution comes off your pay before Income Tax is worked out, so relief is automatic at your highest rate. Under relief at source, used by many private workplace and personal pensions, you pay in from taxed pay and the provider claims 20 per cent from HMRC to add to your pot. The difference matters most for people earning below the Personal Allowance of £12,570, who get no relief under net pay.

Net pay: how public sector schemes work

In a net pay scheme, payroll takes your pension contribution from your gross pay and then works out tax on what is left. Say you work for the NHS in England on £32,073, the entry point of band 5. Your contribution rate is 8.3 per cent, or about £2,662 a year. Your taxable pay is £32,073 minus £2,662, so about £29,411, and Income Tax is charged on that.

The contribution is never taxed, so the relief equals the tax you would otherwise have paid on it. For this nurse that is 20 per cent, so the £2,662 contribution costs about £2,130 from take-home pay. A higher rate taxpayer gets 40 per cent relief automatically in the same way, with nothing to claim.

National Insurance is still worked out on the full £32,073, since net pay contributions do not reduce NI.

The four main public sector schemes all use this method:

• NHS Pension Scheme
• Teachers’ Pension Scheme
• Local Government Pension Scheme
• Civil Service pension (alpha)

Relief at source: how many private pensions work

In a relief at source scheme, your contribution is taken from pay after tax. The pension provider then claims basic rate relief from HMRC and adds it. Pay in £80 and the provider claims £20, so £100 goes into your pot.

Higher and additional rate taxpayers get only the basic 20 per cent added automatically. The rest has to be claimed, usually through Self Assessment or by contacting HMRC, and it comes back as a tax refund or a tax code change. Many people never claim it.

Auto-enrolment schemes such as NEST commonly use relief at source. The legal minimum for auto-enrolment is 8 per cent of qualifying earnings in total, at least 3 per cent from the employer, and the employee’s 5 per cent includes tax relief. See our auto-enrolment guide for the earnings band.

The low earner gap

The two methods give different results here. Under net pay, relief exists only if you would have paid tax. Someone earning under £12,570 pays no Income Tax, so a net pay contribution saves them nothing.

Under relief at source, the 20 per cent is added even if you pay no tax at all. A non-taxpayer paying £80 still gets £100 in the pot.

Say a part-time school cook earns £11,000 a year from a council and pays into the LGPS main section at 5.5 per cent, which is £605. Their pay is below the Personal Allowance, so they would have paid no tax anyway, and the £605 costs the full £605. In a relief at source scheme, the same person paying £605 would have about £756 invested.

This affects a lot of part-time public sector staff, such as lunchtime supervisors, cleaners and others on a few hours a week. The employer contribution and the pension the scheme promises are separate from tax relief and unaffected by it, but the gap explains why some payslips show no tax saving on the pension line. Our guide to public sector pensions for part-time staff covers how the schemes treat part-time pay.

Government has been reviewing the rules on low earners in net pay schemes. Check gov.uk for the current position on any top-up for affected members.

Scottish taxpayers

Relief at source schemes add 20 per cent for everyone, even though Scottish rates differ. A Scottish starter rate taxpayer pays 19 per cent but still gets 20 per cent added, and HMRC does not take the difference back. Intermediate rate taxpayers pay 21 per cent and can claim the extra 1 per cent. Higher, advanced and top rate taxpayers can claim the rest of their relief above 20 per cent.

In net pay schemes, Scottish taxpayers get relief at their own rate automatically, the same as everyone else.

Salary sacrifice compared

Salary sacrifice is a third route. Your contract reduces your pay and your employer pays the contribution. Your salary is lower, so you save National Insurance as well as tax. Public sector schemes rarely use it for the main contribution, though some employers offer it for additional voluntary contributions. Our guide to salary sacrifice explains the trade-offs.

Limits on relief

Tax relief is given only on contributions up to your earnings for the year, or a basic amount if you have no earnings, and an annual allowance sets a level above which tax charges can apply. Most public sector staff are well under it, but senior doctors and leaders can be caught; see the pension annual allowance guide.

On how much to pay in or whether to transfer, the scheme’s own administrator answers questions about your benefits, and MoneyHelper (the government-backed guidance service) or a regulated financial adviser can help with choices.