Should you maximise your annual tax-free pension allowance?

Each tax year, you can shield up to £60,000 from the taxman in a pension. Should you take advantage of this allowance, or is the money better off elsewhere?

Plants growing out of a pile of money, symbolising a growing pension pot.
(Image credit: Getty Images - Jose A. Bernat Bacete)

Chancellor Jeremy Hunt raised the annual pension contribution allowance from £40,000 to £60,000 – but only a third of high net worth individuals are taking advantage, according to the latest Saltus Wealth Index Report

This means that many people are missing out on the opportunity to shield their money from the taxman. 

At a time when the cost of living is soaring and many fear they won’t have enough money to achieve a comfortable retirement, topping up your pension is more important than ever. In fact, recent research shows that younger savers could need as much as £1 million in their retirement pot to fund their golden years.

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But as interest rates remain high and mortgage costs become more of a burden, many face a string of conflicting priorities. If you have a mortgage or debts, should you prioritise overpaying those first? And what if you value flexibility? Could an ISA be a better option if you think you might need to access the money before you hit retirement age?

We weigh up all the considerations – including what a Labour government could mean for your pension allowance

Should you top up your pension?

Pensions are a tax-efficient way to save for retirement, so topping up your pension could be a good idea if you have got some cash to spare. 

To encourage savers to plan for the future, the government offers a range of incentives. The main one is pension tax relief – a measure which effectively refunds you the income tax you originally paid on the money when you first earned it. 

For example, if you are a basic-rate taxpayer and you put £80 into your pension, HMRC will gross it back up to £100 to refund you for the 20% tax you paid originally. Similarly, if you pay 40% or 45% tax, then you only have to pay £60 or £55 into your pension pot for the government to top it back up to £100. 

All savers get the 20% basic-rate tax back immediately. However, if you are a higher or additional-rate taxpayer, you will need to claim the rest back yourself. You can do this by filling out a self-assessment tax return form. 

Another tax perk is that any capital gains or income you earn in your pension is shielded from the taxman. This will become even more valuable as we enter the new tax year, as the capital gains and dividend allowance are both being halved from 6 April

In shielding you from income and capital gains tax, pensions are a bit like ISAs. The main difference is that you can stash up to £60,000 in your pension each year without paying any tax, while you can only put up to £20,000 in an ISA over the same period. 

You can also access an ISA far more easily than your pension, if you need to make withdrawals. Meanwhile, you will have to wait until you are 55 to access the funds in your pension. This will increase to 57 in April 2028. 

If you would like to explore the pros and cons of each option, see our recent article on ISAs versus SIPPs

How does the annual tax-free pension allowance work?

Last year, Hunt raised the annual tax-free pension allowance from £40,000 to £60,000. But what exactly does this mean?

The annual pension allowance is the maximum amount you can pay into your pension pot, while still receiving tax relief from the government at your marginal rate. This £60,000 allowance includes contributions from yourself, your employer and HMRC (in the form of tax relief). 

If you exceed this allowance, you will no longer benefit from the 20%, 40% or 45% tax refund.

Is everyone entitled to the annual pension allowance?

If you are a very high earner, and your annual taxable income exceeds £260,000, you will not be entitled to the full allowance. Instead, it will be docked by £1 for every £2 of income that you earn over the threshold. 

The maximum reduction is £50,000 – so everyone has an annual pension allowance of £10,000, no matter how much they earn. 

For example, if you earn £300,000 per year, then your income is £40,000 over the threshold. This means that £20,000 will be docked from your annual allowance. In other words, your annual tax-free pension allowance will be £40,000. 

Meanwhile, if you earn £360,000 or more, then your allowance will be reduced by the full amount and you will only be able to pay £10,000 into your pension each year tax-free.

What is the lifetime pension allowance and has it been abolished?

There is another limit called the lifetime pension allowance, however this is about to be abolished. Jeremy Hunt announced the change in his 2023 Spring Budget, and it will come into effect on 6 April 2024.

The lifetime allowance is essentially a limit on how big your pension pot can get before you are subject to a hefty tax penalty. The current lifetime allowance (prior to 6 April 2024) is £1,073,100. If your pension savings are higher than this when all of your pots are added together (apart from your state pension), then you are taxed on the excess when you withdraw it.

If you withdraw the excess as a lump sum, it is taxed at 55%. If you take an income from the excess, it is taxed at 25% (plus income tax). 

Inflation and a rise in the cost of living mean that a £1 million pension pot isn’t as big as it sounds. Indeed, recent research from Interactive Investor actually revealed that younger savers will need to build a pension pot worth almost £1.1 million, if they want to enjoy a comfortable retirement. As such, many will be glad to see the lifetime allowance scrapped. 

That said, one thing to keep an eye on is what a change in government could mean for the rules, as Labour has been critical of the Conservatives’ decision to scrap the lifetime allowance. 

At the time of the 2023 Spring Budget, shadow chancellor Rachel Reeves referred to Hunt’s decision as “a one billion pound pensions bung for the one per cent”, adding that the move would “widen the cost of living chasm”. There is some suggestion that the Labour party could reintroduce the lifetime allowance if elected, which could mean paying tax on any excess pension savings.

Should you prioritise your pension or your mortgage?

A common question for many people when they have a bit of spare cash is: where is the best place for me to put this? Should I pay off my debts first or save for the future? The biggest debt that most people will acquire in their lifetime is their mortgage. So are you better off overpaying your mortgage each month, or topping up your pension pot?

A good rule of thumb is to look at the interest rate you are paying on your mortgage and whether you are likely to earn a higher rate of return from the investments in your pension. 

If interest rates are really low, like they were between 2009 and 2021, then you could be better off going down the pension route. The base rate was below 1% for the majority of that period, which meant mortgage rates were low too. For comparison, the stock market averages an annual return of around 10% over the long-run. 

Of course, your pension won’t just hold stocks – and depending on your age, you may be invested in lower-risk, lower-returning assets. This means that the above rule is just a rough guide. Nobody knows exactly where investment markets are going to go in a given year, and interest rates can go up and down too. We have seen strong evidence of this over the past couple of years.

Interactive Investor did some research on this topic last year. Alice Guy, head of pensions and savings at the platform, said: “Without a crystal ball it’s difficult to say which is a better option as the outcome largely depends on the level of interest rates and stock market performance”.

“Of course, in reality interest rates don’t remain static, and you may therefore decide to prioritise overpaying your mortgage or pension at different times”, she added.

Guy also highlights the fact that you should only use spare cash to overpay your mortgage – you shouldn’t reduce your existing pension contributions to redirect the funds into your house. The reason is that, by doing this, you will potentially lose free employer contributions.

“It’s also worth pointing out that pension tax relief could make a big difference to your decision”, Guy adds. “There’s a risk that someone who pays off their mortgage first and then maxes out their pension contributions could miss out on valuable tax relief if their pension contributions outstrip their taxable earnings”, she explains.

In other words, there is potentially an opportunity cost associated with choosing your mortgage over your pension, as you will miss out on the tax relief you could have earned, had you decided to put the money in your retirement pot instead.

Katie Williams
Staff Writer

Katie has a background in investment writing and is interested in everything to do with personal finance, politics, and investing. She enjoys translating complex topics into easy-to-understand stories to help people make the most of their money.

Katie believes investing shouldn’t be complicated, and that demystifying it can help normal people improve their lives.

Before joining the MoneyWeek team, Katie worked as an investment writer at Invesco, a global asset management firm. She joined the company as a graduate in 2019. While there, she wrote about the global economy, bond markets, alternative investments and UK equities.

Katie loves writing and studied English at the University of Cambridge. Outside of work, she enjoys going to the theatre, reading novels, travelling and trying new restaurants with friends.