UK Pensions - Relief at source versus net pay: why does it matter and what is the solution?

Employers should be aware that there are two different ways of enabling employees to get tax relief on their pension contributions to defined contribution (DC) pension schemes. If employees are earning below the income tax threshold and contributing to a “net pay” scheme, they will be missing out on a government top-up. Employers could face criticism (or even claims) if their pension arrangements are not appropriate for their staff.

What is the government top-up?

When employees contribute to their pension scheme, they get tax relief on their contributions. This means that some of the employee’s pay, which would otherwise have gone to the government as tax, instead goes into their pension pot. The government call this a pension top-up and it is paid at the employee’s highest rate of income tax.

For example, a basic rate taxpayer contributing £100 to their pension scheme would actually only have to pay £80 – the additional £20 is essentially a government top-up because the employee doesn’t have to pay tax on this £100 of salary and so saves £20 of tax.

Net pay v relief at source

Tax relief on pension contributions may be given in two ways: “net pay” or “relief at source”:

  • In a net pay scheme, contributions are deducted from the employee’s gross salary (i.e. before tax has been deducted). The employee then pays tax only on salary “net” of (i.e. after deducting) the contributions. This means that the employee automatically receives tax relief at his or her highest rate of income tax.
  • In a relief at source scheme, contributions are deducted from the employee’s net salary (i.e. after tax has been deducted). However, the employer deducts only 80% of the total contribution from the employee’s salary; the scheme then adds an amount equal to basic rate tax relief, which it then reclaims from HMRC. The key point to note is that the scheme adds this top-up to the employee’s contribution whether or not the employee is earning enough to pay tax in the first place.

A scheme can only use one method for all members and this affects lower or higher paid staff in different ways:

  • Employees who don't pay income tax only get the government top-up in relief at source schemes. If the scheme is a net pay scheme, these employees won’t get tax relief and will have to pay 20% more for their pension. In our example above, the difference means that employees would pay £100 to a net pay scheme and get no tax saving; in contrast, they would pay only £80 to a relief at source scheme, to which the scheme would then add £20 to make up the total of £100.
  • Higher and additional rate taxpayers only get their full tax relief “up front” in a net pay scheme. If the scheme is a relief at source scheme, these members get only basic rate tax relief up front and need to reclaim the balance of their full tax relief (40% for higher rate taxpayers and 45% for additional rate taxpayers) by completing a self-assessment tax return (or writing to HMRC).
Are there any plans to fix the problem?

The government has recently published a call for evidence on the operation of the two methods of administering pensions tax relief and what improvements might be made. The call for evidence suggests four possible ways of addressing the difference in treatment for low earners:

  • Suggested approach 1: HMRC would pay a bonus to lower earners in net pay schemes in order to put them in the same position as lower earners in relief at source schemes.
  • Suggested approach 2: HMRC would apply a standalone charge to recover (i.e. claw back) the top-up given under the relief at source method of tax relief for low paid contributors who haven’t paid tax.
  • Suggested approach 3: employers would be required to provide two schemes for their employees – one net pay and one relief at source. Employers would switch employee contributions between schemes depending on whether their earnings would take them over the personal allowance for that pay period.
  • Suggested approach 4: all DC schemes would be required to operate relief at source.
What happens next?

The call for evidence closes on 13 October. However, the tone of the call for evidence is not particularly positive, with the government noting that: “To date a proportionate and straightforward solution to address the difference in treatment for low earning pension savers has not been found. There is a balance to be struck between ensuring consistency in outcomes and ensuring simplicity for individuals. The options considered in this call for evidence all have drawbacks and would introduce significant complexity into the pensions tax regime for employers and pension schemes. Any changes would be difficult to explain to individuals and are likely to lead to greater engagement with HMRC by individuals who would otherwise have no need to contact them."

Until a government solution to this issue is implemented, employers should be considering the points highlighted above.

For more information, please speak to your usual Linklaters contact.