Net pay and relief at source

This article is for financial advisers only. It mustn’t be distributed to, or relied on by, customers. It’s based on our understanding of government guidance and announcements made at the date of publication.  


In the October 2021 Budget, the government published their response to last year’s ‘call for evidence’ aimed at reviewing options for addressing the different ways pension schemes administer tax relief.  This relates to an anomaly that currently exists between the ‘net pay’ and ‘relief at source’ methods of giving tax relief on pension contributions made by an individual.

The issue particularly affects low earners and became more prominent following the final set of auto-enrolment contribution increases in April 2019.

To address this, the government plan to introduce a system of ‘top-up’ payments to low earners in net pay arrangements in respect of personal contributions made from 2024/25 onwards. The Autumn Budget and Spending Review 2021 estimates around 1.2 million individuals could benefit from the top-up by an average of £53 per year. The cost to the government of introducing the top-up is projected to be £10 billion in 2024/25 and £15 billion in 2026/27. 

This article explains what the issue is in practical terms, but it’s worth summarising first how the net pay and relief at source methods both work.

Tax relief on pension contributions is given in the UK primarily to encourage pension saving. Personal contributions receive tax relief in different ways depending on the type of pension scheme or arrangement they are being paid to.

The ‘net pay arrangement’ is commonly used for occupational pension schemes whereas ‘relief at source’ is used for personal pension schemes. Here’s a description of both:

Net pay arrangement
An employer deducts gross contributions from an employee’s gross pay before calculating income tax using Pay As You Earn (PAYE). In this way the employee should get tax relief immediately at their highest marginal rate. If an employee doesn’t earn enough to pay income tax, they won’t get any tax relief. When submitted to the scheme provider, there is no tax relief claimed from HM Revenue and Customs (HMRC).

Relief at source
An individual’s contributions are paid net of basic rate tax. The pension provider sends a claim to HMRC for the basic tax relief due and applies it to the member’s pension arrangement. Anyone paying tax at higher than basic rate can claim further tax relief due directly from HMRC. Where an employer collects an employee’s pension contributions from their salary, they must make sure the net contribution is deducted from net pay after income tax is calculated. If, in error, the contribution is deducted as a net amount from gross pay, the employee will effectively receive double tax relief on their contribution. This will, when discovered, have to be corrected.

As you can see, the terminology can be confusing. For the net pay arrangement, contributions are deducted as a gross amount from gross pay before income tax is calculated. Conversely, for relief at source, contributions are deducted as a net amount from net pay after income tax has been calculated.

The anomaly that currently exists relates to employees who don’t pay income tax as a result of their income being below the personal allowance (£12,570 for 2021/22) and can be best explained using an example:

Assume two employees earn £12,000 in the 2021/22 tax year. One is a member of his employer’s occupational pension scheme whereas the other is a member of her employer’s group personal pension scheme. Under the minimum auto-enrolment requirements, both are entitled to contributions of 8% of qualifying earnings (5% gross from the employee and 3% gross from the employer).

Firstly, let’s look at the pension contributions in 2021/22 for each employee. For auto-enrolment purposes, qualifying earnings in 2021/22 are earnings above £6,240 so the minimum pension contributions would be: 

  Net pay (OPS) Relief at source (PP)
5% gross employee contribution  5% x (£12,000 - £6,240) = £288pa1 5% x (£12,000 - £6,240) = £288pa – 20% = £230.402
3% gross employer contribution  3% x (£12,000 - £6,240) = £172.80pa

1 The employer will deduct the gross contribution from gross pay and the full amount will be paid into the occupational pension scheme.

2 The employer will deduct the contribution, net of basic rate tax, from the post-tax salary so the £230.40 will become £288 when the personal pension provider claims the 20% tax relief from HMRC.

Now, let’s look at their tax position: 

     Net pay (OPS)
Gross pay £12,000
Deduct 5% gross employee contribution £288
Apply income tax £0*
Take-home pay £11,712
     Relief at source (PP)
Gross pay £12,000
Apply income tax £0*
Deduct 5% net employee contribution £230.40
Take-home pay £11,769.60

*As gross pay is less than the personal allowance of £12,570 for 2021/22, there’s no income tax due.

So, although the gross pension contributions made under the net pay and relief at source methods are the same, the employee in the personal pension scheme is better off by £57.60 as she is benefitting from 20% tax relief on her personal contributions, even though she doesn’t pay any income tax. For simplicity, the example ignores employee National Insurance contributions that would be due on each employee’s gross pay.

The above example highlights that an employee will only get tax relief on their own personal contributions under net pay when they pay income tax on their earnings. To illustrate that point, we’ll look at two employees with earnings in 2021/22 of £15,000. Their pension contributions in 2021/22 would be:

  Net pay (OPS) Relief at source (PP)
5% gross employee contribution  5% x (£15,000 - £6,240) = £438pa1 5% x (£15,000 - £6,240) = £438pa – 20% = £350.40pa2
3% gross employer contribution  3% x (£15,000 - £6,240) = £262.80pa

The employer will deduct the gross contribution from gross pay and the full amount will be paid into the occupational pension scheme.

The employer will deduct the contribution, net of basic rate tax, from the post-tax salary so the £350.40 will become £438 when the personal pension provider claims the 20% tax relief from HMRC.  

Their tax position would be: 

     Net pay (OPS)
Gross pay £15,000
Deduct 5% gross employee contribution £438
Apply income tax (£14,562 - £12,570) x 20% = £398.40
Take-home pay £14,163.60
     Relief at source (PP)
Gross pay £15,000
Apply income tax (£15,000 - £12,570) x 20% = £486
Deduct 5% net employee contribution £350.40
Take-home pay £14,163.60

You can see in this example that both the net pay and relief at source methods produce the same results - take-home pay is the same and the gross pension contributions are the same under both methods. For simplicity, the example ignores employee National Insurance contributions that would be due on each employee’s gross pay.

Summary

Although the difference in one year could be a relatively small amount (£57.60 in take-home pay in the 2021/22 tax year for an employee earning £12,000), when you factor in this happening in other tax years there could end up being a notable disparity between those making personal contributions through the net pay method as opposed to relief at source.

The government’s proposed system of top-up payments, whilst not expected to be implemented until 2024/25, should bring an end to this anomaly.

Pensions Technical Services