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.

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.

TECHTALK This article originally appeared in JAN 15 edition of techtalk. Please visit www.scottishwidows.co.uk/techtalk for the latest issue.

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.

EXAMPLEAshok 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 Pension 3% employer contribution £60 3.2% member contribution (4% net of 20% tax relief) £64 20% tax relief £16Total contributions £140

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.

EXAMPLEMinesh 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 £60 4% gross member contribution £80Total 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.Scottish Widows plc. Registered in Scotland No. 199549. Registered Office in the United Kingdom at 69 Morrison Street, Edinburgh EH3 8YF. Telephone: 0131 655 6000.Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number 191517.