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Contracting out of the additional State Pension

If you are an employee with annual earnings above a certain amount (£5,564 in 2012-2013) you can choose to leave the additional State Pension scheme. You can join a private pension scheme instead. This is called 'contracting out'. It is not possible to leave the basic State Pension.

How does contracting out work?

Contracting out works by you choosing to join your employer's occupational pension scheme. When you join the scheme, both you and your employer will pay lower, reduced rate National Insurance contributions. When you retire, your second pension will come from your employer's scheme and not from the additional State Pension.

Contracting out to a stakeholder or personal pension

You can also contract out with a stakeholder pension or a personal pension. If you do this, you will not pay lower National Insurance contributions. Instead, once a year HM Revenue & Customs will pay directly into your pension a rebate of your National Insurance contributions. The rebate is intended to provide benefits broadly the same as the additional State Pension given up.

You can also join a stakeholder pension scheme or a personal pension scheme without contracting out of the additional State Pension. If you do this, you won't get the rebate.
You will usually get tax relief on your contributions to a stakeholder or personal pension scheme. You pay Income Tax on your earnings before any pension contribution, but the pension provider claims tax back from the government at the basic rate of 20 per cent. In practice, this means that for every £80 you pay into your pension, you end up with £100 in your pension pot.

If you pay tax at higher rate, you can claim the difference through your tax return or by telephoning or writing to HMRC.

If you’re an additional rate taxpayer you’ll have to claim the difference through your tax return.

Contracting out to a ‘rebate only’ scheme

Some occupational schemes and personal pensions are organised on a 'rebate-only' basis. This means that the only money being paid into the scheme is your National Insurance contributions rebate.

You need to bear in mind that what you get with a 'rebate only' pension is based on how well your funds have been invested. The amount of pension you get with your new scheme may not be the same as the additional State Pension you would have received. You may need to think about whether this will be enough to support the lifestyle you want when you retire.

Changes to contracted out pensions from 2012

From 6 April 2012, you won't be able to contract out of the State Second Pension by joining:

  • a personal or stakeholder pension scheme
  • a contracted-out money purchase ('defined contribution') occupational pension scheme

Find out more about the changes, including what will happen if you're already paying into one of these schemes, by following the link below.

If you’ve contracted out into a final salary occupational pension scheme you’ll not be affected by the changes.

If you are already contracted out

If you are already contracted out through either type of scheme, you will:

  • be able to continue to make your own contributions to the scheme
  • be able to continue to benefit from any employer contributions to the scheme
  • no longer be able to benefit from any rebate of National Insurance contributions

Contracting out through an occupational salary-related (defined-benefit) scheme will still be allowed. However, contracting out for these schemes will be reviewed in the future.

More useful links

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