Net pay and relief at source

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This case study 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 March 2020 Budget, the UK government announced they would publish a call for evidence aimed at reviewing options for addressing the different ways pension schemes administer tax relief.

This was mainly in response 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 highlighted particularly affects low earners and became more prominent following the final set of auto-enrolment contribution increases in April 2019.

The call for evidence has now been published, with the government looking for responses to be made by the closing date of 13 October 2020.

This case study 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. For personal contributions made by an individual there are different ways that tax relief is provided depending on the type of pension scheme or arrangement that contributions are being paid to.

The net pay method is commonly used for occupational pension schemes and most master trust schemes whereas relief at source is used for personal pension schemes and by a small number of master trust schemes. Here’s a description of both:

Net pay

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.

Relief at source

An individual’s contributions are paid net of basic rate tax. The pension provider sends a claim to HM Revenue and Customs for the basic rate 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.

As you can see, the terminology can be confusing. For the net pay method, 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 that don’t pay income tax as a result of their income being below the personal allowance (£12,500 for 2020/21) and can be best explained using an example:

Assume two employees earn £12,000 in the 2020/21 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 2020/21 for each employee. For auto-enrolment purposes, qualifying earnings in 2020/21 are earnings above £6,240 so the minimum pension contributions would be:

  Net pay Relief at source
5% gross employee contribution  5% x (£12,000 - £6,240) = £288pa 5% x (£12,000 - £6,240) = £288pa*
3% gross employer contribution 3% x (£12,000 - £6,240) = £172.80pa  3% x (£12,000 - £6,240) = £172.80pa

 

 

*The 5% net employee contribution is £230.40 per year but will become £288 per year when invested in the personal pension with the addition of 20% tax relief.

 

 

Now, let’s look at their tax position:

 

  Net pay   Relief at source
Gross pay £12,000 Gross pay £12,000
Less 5% gross employee contribution  £288 Income tax £0*
Income tax £0* Less 5% net employee contribution  £230.40
Take-home pay £11,712 Take-home pay £11,769.60

 

*As gross pay is less than the personal allowance of £12,500 for 2020/21, 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 benefiting from 20% tax relief on her personal contributions, even though she does not pay any income tax. For simplicity, the example ignores employee National Insurance contributions that would be due on each employee’s gross pay.

This example highlights that an employee will only get tax relief on their own personal contributions under the net pay method when they pay income tax on their earnings.

To illustrate that point, we’ll look at two employees with earnings in 2020/21 of £15,000. Their pension contributions in 2020/21 would be:

  Net pay Relief at source
5% gross employee contribution  5% x (£15,000 - £6,240) = £438 per year 5% x (£15,000 - £6,240) = £438 per year*
3% gross employer contribution 3% x (£15,000 - £6,240) = £262.80 per year  3% x (£15,000 - £6,240) = £262.80 per year

 

*The 5% net employee contribution is £350.40 per year but will become £438 per year when invested in the personal pension with the addition of 20% tax relief.

Their tax position would be:

  Net pay   Relief at source
Gross pay £15,000 Gross pay £15,000
Less 5% gross employee contribution £438 Income tax (£15,000 - £12,500) x 20% = £500
Income tax (£14,562 - £12,500 x 20% = £412.40 Less 5% net employee contribution £350.40
Take-home pay £14,149.60 Take-home pay £14,149.60

 

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 2020/21 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.

It will be interesting to see the outcome of the government’s call for evidence. They are essentially looking for comments on the following four proposals although they do ask respondents to suggest any other solutions that could possibly work:

  • Paying a bonus to lower earners in net pay schemes based on Real Time Information (RTI) data.
  • Deducting a standalone charge from employees in relief at source schemes who don’t pay tax.
  • Employers operating relief at source and net pay so that no employee is disadvantaged (eg, lower earners use relief at source and others use net pay).
  • Making it a requirement to use relief at source for all defined contribution schemes regardless of whether they are occupational schemes, master trust schemes or personal pension schemes (several options are listed such as introducing a requirement for all new and existing schemes to use relief at source, introducing the requirement only for new schemes or introducing the requirement only for low earners).

 

Pensions Technical Services