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Low earners set for pay boost as tax quirk to be fixed

Paloma Kubiak
Written By:
Paloma Kubiak

More than a million low earners will see their take home pay rise as the government has finally addressed a pensions tax anomaly.

Around 1.2 million low earners could see their wages rise by hundreds of pounds from 2025 as the government confirmed it would “correct the injustice” of a long-standing pensions tax quirk.

It relates to the way pension contributions are treated for workers who earn above the auto-enrolment earnings trigger of £10,000 but below the personal allowance (currently £12,570).

Some workers come under the ‘net pay arrangement’ where pension contributions are deducted before income tax is calculated, whereas ‘relief at source’ means pension contributions are deducted after.

Since 2015, people saving through a ‘net pay arrangement’ have had less take home pay compared to similar earning savers who use a ‘relief at source’ scheme. This is because those using the latter type of pension scheme receive a 20% top-up from the government on their savings, while those using NPAs receive tax relief at their marginal rate – 0% (see below for a worked example).

For those on the ‘net pay arrangement’, they’re more likely to be women, Treasury analysis revealed.

The government said it has published legislation confirming that low earners saving through the NPA will get the same level of government top-up as those who use ‘relief at source’.

It estimated that following the change, around 200,000 people are set to see take-home pay rise £100, while the average worker will see wages rise by £53 extra a year.

‘Correcting this injustice’

Financial secretary to the treasury, Lucy Frazer, said:A quirk in our pensions tax system has meant that over a million low-earners have lost out on government top-ups to their pensions, resulting in comparatively less take home pay.

“We are correcting this injustice so low earners will get the same level of government support, no matter what type of pension they use.”

‘Perverse lottery’

Jon Greer, head of retirement policy at Quilter, said: “After many years of outcry from the industry, the government finally committed to addressing the inherent inequality for low earners in pension net pay schemes versus relief at source schemes.

“The Conservative party manifesto recognised the problem and pledged to solve the issue all the way back in November 2019. By the time it is eventually fixed, hundreds of millions will have been lost in pension funds by 1.2 million lower earners, three quarters of whom are women.

“The net-pay tax flaw means some workers earning £12,570 a year or less could retire with a pot worth thousands of pounds less than others. This is because people enter into a perverse lottery where those who are in a net-pay pension scheme don’t benefit from government tax relief into their pension pots, while other workers who are in a ‘relief at source’ scheme receive the top-up.

“While it is laudable that the government is actually tackling the problem, its solution remains imperfect, but at least better than the current situation, as it commits to paying a top-up contribution directly to the person’s bank account. However, this ultimately means they will lose out on potential growth by not having the money held in the pension fund and invested.”

Tom Selby, head of retirement policy at AJ Bell, said: “It is a scandal that over one million of the UK’s lowest earners miss out on valuable pension tax relief as a result of the so-called ‘net pay anomaly’.

“While the government deserves some credit for delivering a solution to the problem and confirming it in legislation, the first payment to those affected won’t go ‘live’ until 2025 – a full decade after the issue first came to light.

“What’s worse, it is those on the lowest incomes – three quarters of whom are women – who have lost out as a result of this administrative cock-up. Those people will sadly continue to lose out for the next three years.

“It’s important to note that for those affected, the money will be paid straight into their bank account rather than their pension. They could, of course, pay the money into their retirement pot if they wanted to.”

An example of the anomaly

Alex and Sam are two employees who earn below the personal allowance. Alex is a member of a pension scheme using NPA and Sam is a member of a pension scheme using RAS.

Both want £500 to go into their scheme. Alex (NPA) has the full £500 contribution deducted before the tax rules are applied to her earnings. She does not have to use any of her personal allowances in order to pay her pension contributions out of untaxed income. Once her pension contribution is deducted the rest of her earnings are taxed but there is no tax to pay. All of the £500 deducted from her earnings goes to the pension scheme.

Sam (RAS) has no tax to pay on her earnings as they are below the personal allowance. The equivalent contribution is paid to her pension scheme as if she had had basic rate tax at 20% deducted from the full £500 contribution. Out of £500 of earnings, £400 is paid to Sam’s RAS pension scheme as a contribution. Although no tax is paid to HMRC, the RAS pension provider is still entitled to claim £100 in tax relief from HMRC so Sam will have £500 in her scheme.

Both Alex and Sam have £500 in their pension scheme but Alex had £500 deducted from her earnings but Sam has only had £400 deducted from her earnings. Sam has more money in her pay packet but she has used up more of her personal allowance to make contributions out of her untaxed earnings. 

However, from 2025, Alex would be eligible for a top-up of £100 to be paid into her bank account. A letter will be sent from HMRC notifying her of eligibility and the need to provide bank account details to HMRC. In future years, HMRC said it should be able to make the payment without Alex needing to supply details.