Relief at source and net pay: avoiding confusion

TECHTALK
This article originally appeared in JAN 15 edition of techtalk. Please visit www.scottishwidows.co.uk/techtalk for the latest issue.
RELIEF AT SOURCE AND NET PAY:
AVOIDING CONFUSION
Bernadette Lewis
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
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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
Quarterly bonus
£200
£2,200
Personal allowance
(£833)
£1,367
Income tax ( £1,367 x 20%)
(£273)
£1,094
Net pension contribution ( £2,000 x 3.2%)
(£64)
£1,030
NICs (£2,200 – £663 x 12%)
(£184)
Net pay
£846
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
Quarterly bonus
£200
£2,200
Gross pension contribution (£2,000 x 4%)
(£80)
£2,120
Personal allowance
(£833)
£1,287
Income tax (£1,287 x 20%)
(£257)
£1,030
NICs (£2,200 – £663 x 12%)
(£184)
Net pay
£846
Pension
3% employer contribution
4% gross member contribution
Total contributions
£60
£80
£140
Pension
3% employer contribution
£60
3.2% member contribution (4% net of 20% tax relief) £64
20% tax relief
£16
Total contributions
£140
Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change.
However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given.
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