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I'm reading about pension schemes in general, and in the UK in particular. I think I have understood how the tax relief works, still I'm not sure.

Given this quote I have found:

If you are a basic rate taxpayer, for every £100 you save into pension, the Government adds £25 in tax relief, making a total of £125.

First, in that example, that £100 are taken after taxes, that's why the government 'adds' £25. In other words, is like if you could get that £100 before taxes, which is £125, and put it into the pension scheme, right? When you start withdrawing the money, do you need to pay the taxes you didn't pay in the past? (in other words, are tasks actually avoided or only deferred?)

However, this is not how ISAs work. In an ISA, you don't get tax relief on the money you put into it, you get tax relief only on dividends, capital gains and bonds returns, is this correct?

That is, coming back to the first example, If I invest £100 in an ISA, the government will not add those extra £25. Instead, if I get a 5% on dividends I won't pay taxes on that particular benefit (in this case £5), correct?

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Assuming we're talking about a money purchase pension and not a final salary pension then yes, you pay into it basically with your pre-tax income. It's therefore more attractive the higher rate of tax that you pay. Any growth in the fund value is tax free but dividends have been subject to corporation tax since 1997

Instead you pay tax on your pension when you start spending it i.e. it counts as part of your income at that point and you'll pay income tax on it each year that you take money out. You'd also usually need to be over 55 (maybe even 58) in order to start taking money out of your pension.

Note that you may well be paying a lower rate of tax once if you've retired at the point you start taking your pension as your income from your pension may well be less than the income from your job prior to your pension.

ISAs work the other way round. You contribute to them with your post tax income and as with pensions growth is tax free and corporation tax cannot be reclaimed.

When you spend your ISA however, that is tax free and you don't pay income tax on it at that point. Unless your ISA is a LISA you can spend it whenever you want - for a LISA you have to be buying a house or over 60 not to pay a penalty when you spend it.

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  • 'Instead you pay tax on your pension when you start spending it ' then the so-called tax relief is not that, it is tax deferral, right? – Martel Apr 18 at 21:11
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    Yes it is, but you may well pay a lower rate of tax as usually your pension income will not be as much as the salary you were earning in employment. And there is a tax free allowance too so if you're pension is small you might not pay tax but then you might also struggle to live on such a small pension. – Robert Longson Apr 18 at 21:12
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(Talking solely about money-purchase, aka Defined Contribution)

Because the income drawn from a pension is taxable, you might well think "pensions are just tax-deferral rather than tax-relief", which would be completely true but for two factors:

  • for many people, their tax bracket while earning will be higher than their tax bracket while retired. For example, someone who is a higher-rate taxpayer (40%) while earning, but only draws enough pension income to be a basic-rate taxpayer (20%) while retired. For such people, they get tax relief at 40% on their contributions, but pay only 20% on withdrawal. Definitely relief, rather than deferral.

  • for everyone, there is the option of taking a 25% lump sum of Tax Free Cash during (usually at the start of) retirement. This is money that has had tax relief applied, but is then NOT re-taxed. Again, definitely relief rather than deferral.

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    If its a work place pension you employer also contributes – Neuromancer Apr 20 at 20:27

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