When you make a personal pension contribution you get basic rate tax relief at source. This means that for every £80 you pay, the government adds £20 – so the effect is as if you had paid in £100. If you’re a basic rate taxpayer, that’s the end of it. But if you’re a higher rate taxpayer, how do you get tax relief at 40%?
Well, you’ll already have had the 20% relief (through the process illustrated above). The additional 20% relief is given by ‘stretching’ your basic rate band by an amount equal to the grossed-up value of the pension contributions. Let’s assume your earnings for 2021/22 are £60,000. You’re going to pay higher rate tax on £9,730 of this (that part of your earnings above the £50,270 higher-rate threshold). Now let’s assume you make pension contributions of £6,000 during 2021/22. The Government will add £1,500 to this, making your ‘grossed up’ contributions £7,500. But something else happens too – to your higher-rate threshold. Whereas, in general, people start paying higher-rate tax at earnings of £50,270, in your case this threshold is ‘stretched’ upwards by £7,500 (the grossed-up value of your pension contributions for the year) to £57,770. So, with your £60,000 income, you will now only pay 40% tax on £2,230 of this, instead of on £9,730 of it. You have, if you like, have remained within basic rate for an additional £7,500 of income – saving you 20% x £7,500 = £1,500 in Income Tax.
So, your total ‘benefit’ is £3,000 – half of which materialised through a £1,500 pension top-up by the Government and the other half of which manifested itself through a reduction of £1,500 in your tax liability.