How pensions are taxed

The big attraction of paying into a pension is upfront tax relief. The government refunds the income tax you have paid on that money and adds it to your pension. So, if you pay £800 into your pension, the government assumes you paid basic-rate income tax on that money at 20% and pays £200 straight into your pension, giving you £1,000 in total. If you are a higher or additional-rate taxpayer you claim further tax relief on your contributions via your tax return. A higher-rate taxpayer would get an extra £200 back and an additional-rate taxpayer earns an extra £250. That brings the net cost of £1,000 in your pension to £600 and £550 respectively.

This process works slightly differently with corporate defined benefit (final salary), as well as with some workplace defined contribution (money purchase) schemes where you pay your contributions out of your gross salary. However, you get the same ultimate level of tax relief.

Limits to the government's generosity

There are limits to how much relief you can get and these take the form of an annual allowance and a lifetime allowance. This applies to all your pensions in total, not per scheme.

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The annual allowance is equal to your relevant UK earnings which very broadly means income from work, but not investment income such as dividends capped at £40,000. So if you earn £30,000, your annual allowance is £30,000, but if you earn £60,000 your allowance is limited to £40,000. However, if you earn more than £150,000 a year, your annual allowance will be tapered away. You lose £1 of your allowance for every £2 you earn over £150,000, down to a minimum allowance of £10,000 for anybody earning over £210,000.

These figures include tax relief. This means the most you can pay into your pension each year is £32,000 as the government will add the other £8,000, taking you to the limit. Note that everybody can pay in £2,880 per year (which increases to £3,600 when the tax relief is added), whether you have that much in earnings or not.

"£1m may sound a lot, but it's possible for your pension to grow this large without paying in huge amounts"

The penalty for paying in too much is an annual allowance charge, which offsets the value of any tax relief gained on excess contributions. This will be added to your tax liability for the year. It is possible to carry forward unused allowances for the previous three years but you must be earning the amount you want to contribute. For example, if you had £10,000 of your annual allowance unused in each of the past three years, you could pay in up to £70,000 this year so long as you have that much in relevant earnings.

Meanwhile, the lifetime allowance limits how large your pension savings can grow. This is now £1m, which may sound like a lot, but given the long-term nature of pensions it is possible for your fund to grow this large without making huge contributions.

If your pension is getting close to being worth £1m, you may need to stop making contributions, or take some money earlier than planned in order to avoid being hit with a charge for exceeding the lifetime allowance. The charge is 25% on anything you draw as an income above the lifetime allowance and 55% if you take the excess as a lump sum. (If you built up more than £1m prior to April 2016, it's possible to lock in a higher limit by contacting HM Revenue & Customs.)

The value of a defined contribution pension for lifetime allowance purposes is simply the value of your pension fund. For defined benefit schemes, the value is calculated as 20 times the pension you have accrued under the scheme, plus any tax-free cash.

Taking your pension

You can access most private and company pensions once you reach 55, although the rules will be different for defined-benefit company pensions. This will rise to 57 in 2028, and continue rising in line with the state pension age (SPA) thereafter, but remaining ten years below SPA). You can take up to 25% of a defined contribution pension fund as a tax-free lump sum, which you can take all at once or spread over a number of years. The rest can be used to buy an annuity to get a guaranteed income, left invested and drawn down over time, or a combination of these options. Defined benefit schemes will pay you a regular income instead, although they may allow you to trade in some of that for a cash lump sum. Either way, the income you get will be subject to income tax at your marginal rate each year.

You can continue paying into a pension after you have taken benefits from another one, but your annual allowance will normally be cut as a result (although there are exceptions, so take financial advice on your options if you are considering doing this). The reduced money purchase annual allowance, which applies in this situation, is just £10,000 and may be retrospectively cut to £4,000 with effect from April 2017 once the government passes the required laws.