Pension Relief at Source and Net Pay

RELIEF AT SOURCE AND NET PAY:  AVOIDING CONFUSION

Original article by Bernadette Lewis (of Scottish Widows) with tables updated by Tom Hatley (of Christopher Little & Co)

We explain the relief at source and net pay methods for giving tax relief when employee pension contributions are deducted from pay.

There’s often confusion about the two methods for giving tax relief on employee contributions to workplace pension schemes. These are:

• Relief at source: this requires net contributions
• Net pay: this requires gross contributions.

Legislation determines which tax relief method a pension scheme uses (assuming that the member in question is eligible for tax relief). Group personal pensions (GPPs) generally use ‘relief at source’ and occupational pension schemes (OPSs) generally use ‘net pay’. Which method a scheme operates determines how employers must deduct employee pension contributions from earnings when running payroll.

If an employer deducts incorrect employee contributions because it’s used the wrong tax relief basis when running payroll, this leads to rework problems for both the employer and the pension scheme. Getting it right is essential, as these two methods are mutually exclusive. Employers need clarity over whether its pension provider operates ‘relief at source’ or ‘net pay’. The employer must then use the correct method when deducting employee pension contributions via payroll. If an employer uses more than one pension scheme, it may have to operate both methods whenever it runs payroll. It must ensure it uses the right method for each scheme and correctly identifies which employees are members of which scheme.

As a related point, employers sometimes don’t understand the significance of salary exchange arrangements for payroll. If an employee has contractually agreed to reduce their earnings in exchange for a higher employer contribution, the employer shouldn’t also be deducting the exchanged employee contribution from their pay. Further comment on this point is outside the scope of this article.

RELIEF AT SOURCE METHOD – NET CONTRIBUTIONS

• Used primarily by GPPs and other contract-based schemes.
•  The employer first deducts income tax under PAYE from the employee’s earnings and then deducts the net member contribution from the employee’s post PAYE earnings. The pension contribution doesn’t reduce the amount of earnings subject to NICs.
• The employee receives basic rate (20%) tax relief at source when they pay their net contribution.
• So an employee who’s required to pay a 1% contribution will see a 0.8% net contribution deducted from their after tax earnings.
• The pension scheme provider reclaims basic rate tax relief from HMRC on the member’s behalf.
• Higher and additional rate taxpayers have to claim further tax relief via their self assessment tax returns. The extra relief is given by extending their basic rate income tax band by the total of their gross contributions.

EXAMPLE

Ashok is a member of a GPP operating relief at source. He’s entitled to employer contributions of 3% of basic pay, conditional on making 4% member contributions. In 2014/2015, his basic pay is £2,000 a month and he receives variable quarterly bonuses.

Ashok’s employer deducts his 3.2% net contribution (4% less 20% tax relief) from his earnings after it has deducted income tax via PAYE. He receives £16 tax relief at source by paying a net contribution of £64 rather than a gross contribution of £80. His employer passes Ashok’s 3.2% net contribution and its own 3% contribution to the GPP provider. The provider reclaims the 20% tax relief given at source on Ashok’s contribution from HMRC. Ashok benefits from total employer and employee pension contributions of £140 and receives £16 tax relief.

 

Basic pay	£2,000.00
Quarterly bonus	£200.00
	£2,200.00
Personal allowance	-£958.30
	£1,241.70
Income tax (£1,241.70 x 20%)	-£248.34
	£993.36
Net pension contribution (£2,000 x 3.2%)	-£64.00
	£929.36
NICs (£2,200 – £680 x 12%)	-£182.40
Personal allowance	£958.30
Net pay	£1,705.26
Pension
3% employer contribution	£60.00
3.2% member contribution	£64.00
20%tax relief	£16.00
Total contributions	£140.00

NET PAY METHOD – GROSS CONTRIBUTIONS

• Used primarily by trust-based OPSs, including final salary and money purchase schemes.
• The employer deducts the gross member contribution from the employee’s earnings before it deducts income tax via PAYE. The pension contribution doesn’t reduce the amount of earnings subject to NICs.
• So an employee who needs to pay a 1% contribution will see a 1% gross contribution deducted from their before tax earnings.
• As the contribution reduces the amount of taxable earnings, the employee normally receives their full amount of tax relief via PAYE, whether they pay basic, higher or additional rate income tax.
• In the unusual situation where an employee doesn’t receive the full amount of tax relief under the net pay arrangement, they make a claim for the balance via their self assessment tax return.

EXAMPLE

Minesh is a member of a money purchase OPS operating net pay. He’s entitled to employer contributions of 3% of basic pay, conditional on making 4% member contributions. In 2014/2015, his basic pay is £2,000 a month and he receives variable quarterly bonuses.

His employer deducts Minesh’s 4% gross contribution from his earnings before deducting tax via PAYE. Using the net pay method reduces his taxable earnings by £80, so he pays £16 less income tax than Ashok (£273 rather than £257). His employer passes Minesh’s 4% gross contribution and its own 3% contribution to the OPS. Minesh benefits from total employer and employee pension contributions of £140 and receives £16 tax relief.

Basic pay	£2,000.00
Quarterly bonus	£200.00
	£2,200.00
Gross Pension Contribution (£2,000 x 4%)	-£80.00
	£2,120.00
Personal allowance	-£958.30
	£1,161.70
Income tax (£1,161.70 x 20%)	-£232.34
	£929.36
NICs (£2,200 – £680 x 12%)	-£182.40
Personal allowance	£958.30
Net pay	£1,705.26
Pension
3% employer contribution	£60.00
4% member contribution	£80.00
Total contributions	£140.00

THE VALUE OF PENSIONS AND INVESTMENTS CAN FALL AS WELL AS RISE AND YOU CAN GET BACK LESS THAN YOU INVESTED.

TAX TREATMENT VARIES ACCORDING TO INDIVIDUAL CIRCUMSTANCES AND IS SUBJECT TO CHANGE.