An Overview of Pensions
Pensions seem to cause more issues and confusion within payroll than they should. We will attempt to simplify and demystify their treatment by providing a brief overview of pensions, focusing on how they are managed within payroll as well as touching on auto-enrolment.
The Tax Treatment of Pensions
There are only three ways a pension can be dealt with for tax purposes:
- Tax Relief at Source. Here the pension is deducted from the net pay, with tax relief at basic rate reclaimed by the pension provider. The gross pay is not affected, and National Insurance Contributions are made as usual.
- Deducted under a net pay arrangement. This is an unhelpful term, but is referring to where the deductions are made before tax, and sometimes referred to as ‘gross for tax’ deductions. Again total gross pay is not affected, and NICs calculated as usual.
- Salary Sacrifice. The employee gives up part of their salary in exchange for a benefit, in this case a pension contribution. Gross pay and NICs will be reduced.
The impact of the tax treatment
- Tax Relief at Source. The employee will receive tax relief, so a top up to their net contribution, at the basic rate at the pension provider, even if they do not pay tax. This method is considered fairer to lower paid workers, but higher rate earners can still claim additional tax relief via their tax return.
The other note with this method is that a contribution of 3% against the gross will actually be seen as a 2.4% contribution on the payslip, with the rest reclaimed as tax relief by the pension provider to bring the total back to the 3% (current basic rate tax at 20%).
- Deducted under a net pay arrangement. The employee receives full immediate tax relief on their contributions, and so higher rate tax payers do not need to make an additional claim via their tax return. The amount of taxable pay is also reduced, which higher paid employees may find useful if they are approaching thresholds. Employees paid below the tax threshold will not receive tax relief.
- Salary Sacrifice. These schemes have become more popular since the introduction of auto-enrolment pensions but they are the most complex. The employee gives up some of their salary, so now the whole contribution is from the employer. For this reason salary sacrifice pensions do not even need to be processed through payroll, although it is more usual to do so. Full tax relief is gained immediately on the contribution as well as reducing the employee and employer NICs.
Care must be taken that the reduced gross pay does not fall below the National Minimum Wage rates, and there are also implications with statutory absence payments as well as other considerations.
The pension calculation basis
Pensions could also be divided in two, as to whether they are based on pensionable pay types or banded earnings. Since the introduction of auto-enrolment Qualifying Earnings has become the most common form of banded earnings, and probably the most common basis for pension calculations.
- Pensionable Pay. Individual elements of an employee’s gross pay may be subject to pension calculations, such as salary only. Sometimes it is all pay, or total gross pay, but some care needs to be taken, as often the intention is all pay subject to National Insurance, so that payments such as business expenses or mileage would be excluded.
For automatic enrolment it is possible to use pensionable pay but the basis needs to be self-certified, usually using one of the predefined sets from The Pensions Regulator.
- Banded Earnings. Qualifying earnings is a band of earnings set by The Pensions Regulator, and is currently the band of earnings between the lower and upper earnings limits for National Insurance. It is possible to have banding other than qualifying earnings, but this now rarely seen.
A brief overview of Pensions?
So three types of treatment for tax, and two for the basis of the contribution. Five items to consider for a basic pension set up in payroll.