Income tax explained

When you're thinking of how much to contribute, you should bear in mind that there is a limited amount that can be paid in without incurring a tax charge.

Generally, you can pay in the equivalent of your entire annual salary each year (or up to £3,600 if this is more) and get tax relief. Your employer can pay in as well.

There is no maximum but the government has put in place an ‘annual allowance’ which includes any money that you pay in and any money that an employer pays in on your behalf, to this plan and any other pension plans you may have.

If you exceed the annual allowance, currently £60,000, you will pay tax on any amount paid above it, even if that amount was paid in by someone else.

If you have earnings over £200,000 a year, and £260,000 a year when total pension contributions are included, your annual allowance may reduce below £60,000 but it won’t be less than £10,000. When you decide to access your pension savings your annual allowance may be reduced depending on the options you choose. This is called the Money Purchase Annual Allowance (MPAA).

There is also a lifetime allowance. If your pot is worth more than the lifetime allowance, you will pay additional tax at your marginal rate of income tax.

These allowances can change with each new tax year, depending on what the government sets out. Download our Tax Year Rates and Allowances booklet to keep up to date on what these allowances are, and how they could affect you

Providing your contributions do not exceed 100% of your UK earnings then they are eligible for tax relief. 

The amount you are entitled to will depend on the rate of tax you pay and may also depend on which country you live in within the UK. The way this works will be set by your employer and depends on the type of scheme, as the government offers two choices:

Relief at source

This is where your employer deducts your contribution from your earnings after tax, and your pension scheme adds tax to your pension at the basic rate, currently 20%.

For example, if you have agreed to pay £100 a month (gross) into your pension, you only need to pay £80 from your take home pay.

Your scheme will then add £20 to this (using the current basic rate of income tax of 20%) bringing the total to £100.

If you pay tax at a higher rate, you'll need to claim any additional tax relief on your self-assessment tax return as the scheme is not allowed to claim back more than the basic rate.

However, if you don’t pay income tax because you’re on a low income, you will still get income tax relief on anything you pay up to 100% of your UK earnings each tax year, or £3,600 (gross) if this is more.

Net pay

Under this method, your employer will take your contributions from your gross salary before any tax is paid. Because of this, you will automatically benefit from tax relief at your highest rate straight away.

If you don’t pay income tax because you’re on a low income, you can still get income tax relief on anything you pay up to 100% of your earnings each tax year, or £3,600 (gross) if this is more, but this is not automatic.

Find out more about claiming income tax relief. 

When you start to take your pension, you can usually take up to 25% of your pension pot as tax-free cash.

Your State Pension, any other income you receive, and interest from some savings and investments could all be taxable. 

If your pot is worth more than the lifetime allowance, you will pay additional tax at your marginal rate of income tax.

Tax rates and allowances can change with each new tax year, depending on what the government sets out. Download our Tax Year Rates and Allowances booklet to keep up to date on what these allowances are, and how they could affect you.

Let’s look at a simple example to explain how this works.

Simone is now in receipt of State Pension and has qualified for the full amount, £203.85 per week in the 2023/24 tax year.

This means a State Pension income of £10,600 per year.

On top of this Simone already has a pension income paying her £13,500 per year. Simone does not have any other income from savings, investments, work or rental properties.

So far Simone has £24,100 income per year £10,600 + £13,500).

This means that after taking into consideration the personal allowance of £12,570, Simone will pay tax at the basic rate on the rest – 20% tax on £11,530. 

You can usually take up to 25% of your pension pot as tax-free cash, either as a lump sum or in stages. If you take more than your tax-free cash, you might have to pay tax on the extra. If the amount you take from your pot is a high value, it could mean that you pay tax at a higher rate than you normally do and in some instances, this could be as much as 45%.

Let’s look at Simone again.

Simone has a defined contribution pension pot worth £100,000 and wants to take £25,000 as tax free cash. This leaves £75,000.

If Simone decided to take the remaining £75,000 as cash in the same year, this would be added to Simone’s other income in order to work out the tax.

Now Simone has £99,100 of income this year (£24,100 + £75,000).

Simone is now earning above £50,270 per year which is above the basic rate tax band. This means that Simone will pay higher rate tax on the difference of £48,830.

Learn more about how you can access your pot and see case studies.

Your allowance for earning interest tax-free is made up of the following:

• personal allowance
• starting rate for savings - depending on your other income
• personal savings allowance - depending on your income tax band

The personal allowance is your usual allowance before you start paying income tax.

If your income is less than £17,570 you may also be eligible to receive the starting rate for savings.

This means that you can earn up to £5,000 of interest from savings without paying tax.

The more you earn from other income (for example your wages or pension), the less your starting rate for savings will be. For every £1 you earn over the personal allowance, your starting rate for savings will be reduced by £1.

Find out more about the starting rate for savings.

On top of the personal allowance and starting rate for savings, there is a personal savings allowance that allows you to earn interest tax free up to a certain amount.

The amount of your personal savings allowance depends on the income tax band you sit in.

The personal savings allowance amounts for the 2023/24 tax year allow you to earn interest tax free up to:

• £1,000 for a basic rate taxpayer
• £500 for a higher rate taxpayer
• £0 for an additional rate taxpayer

Let’s look at an example.

Sumesh works part time and earns £14,570 per year. He has considerable savings and has received interest of £3,600 this year.

• Income = £14,570
• Personal allowance = £12,570
• Income (£14,570) - Personal allowance (£12,570) = £2,000
• Starting rate for savings = £5,000
• Starting rate for savings is reduced £1 for every £1 you earn over the personal allowance
• Starting rate of savings (£5,000) - Income above the personal allowance (£2,000) = £3,000

On top of the starting rate for savings, Sumesh is also eligible for the personal savings allowance. As a basic rate tax payer, Sumesh can receive up to another £1,000 in interest before paying tax.

• Sumesh's starting rate for savings (£3,000) + Personal savings allowance (£1,000) = £4,000

In total, this means Sumesh can earn £4,000 in interest without paying tax. As he only earned £3,600 he won't have to pay any tax on the interest.

The interest earned from the following savings are covered by this allowance:

• bank and building society accounts 
• savings and credit union accounts
• unit trusts, investment trusts and open-ended investment companies
• peer-to-peer lending 
• trust funds

Your allowance also applies to interest from:

• government or company bonds
• life annuity payments
• some life insurance contracts

Individual Saving Accounts (ISAs) are tax-efficient savings plans, meaning that the interest or growth you earn on an ISA is tax free.

Interest earned in an ISA does not count towards your personal allowance, starting rate for savings or personal savings allowance although the government does set limits on the amount you can save into an ISA each tax year.

Learn more about ISAs.

Take a look at our Tax Year Rates and Allowances booklet to see the current ISA allowance.