You make your contributions from your net (taxed) income and the pension provider then reclaims the tax you have already paid on this money and invests it in your pension.
The effect of this for basic-rate taxpayers is that, for every pounds 77 you pay in, pounds 100 is invested in the fund.
Those paying 40 per cent income tax fare even better. They have to pay only pounds 60 into their pension scheme for a pounds 100 investment to be made.
Because of this generous tax treatment, there are limits on the amount you can invest.
If you have not made the maximum tax-free contributions to which you are entitled, it may not be too late to make these up, explains Craig Foreman, of the independent financial advisers MPL.
He says: "The carry-back rules allow people to use up any relief from the previous year that they haven't already used. The carry-forward rules then allow you to catch up on any missed premiums in the previous six years."
The rules are quite complex, so it is worth getting professional help. The ideal way to build up your pension is to start early and make adequate regular contributions.
If you got off to a slow start, then you should look to make up for this as soon as possible by increasing your contributions and, where possible, using up unused relief from previous tax years.
This can be particularly advantageous for the over-50s who may now have more money to invest in their pensions as a result of their children having grown up and the mortgage having been paid off.
Under the personal pension rules, you can start to draw benefits from your pension once you hit age 50. You can take up to 25 per cent of your pension money as tax-free cash, and the rest must be used to buy an annuity whose purpose is to provide you with an income for the rest of your life.
If you reach your 50s and have not put as much into your pension as you would like, then by using the carry-back and carry-forward rules you can invest large sums for a relatively small outlay, and so rapidly boost the size of your pension pot.
Say you have pounds 50,000 of unused relief. As a higher-rate taxpayer you could pump this much into your pension with a net contribution of pounds 30,000 (the other pounds 20,000 comes from reclaimed tax).
You can then immediately withdraw 25 per cent (pounds 12,500) of this tax- free. So your net investment would be pounds 17,500 (your original pounds 30,000, less the pounds 12,500 cash you took back) but you would have boosted your pension pot by pounds 37,500 (the pounds 50,000 invested in your pension, less the pounds 12,500 cash you took).
"If people can afford it, this is one way for late arrivals at the pension party to give themselves a reasonable-sized pension fund for a relatively low cost," says Mr Foreman.
Even if you are on the verge of retiring, you may still be able to take advantage of the tax rules, says Peter Quinton, managing director of the Annuity Bureau.
Say you are in the last year of contributing to your pension scheme before you start taking benefits, and pounds 10,000 can still be invested in your pension.
As a higher-rate taxpayer, you would require a net contribution of only pounds 6,000 to make the pounds 10,000 investment .
Once this contribution is made, you then withdraw 25 per cent of the pounds 10,000 as tax-free cash, leaving pounds 7,500 (pounds 10,000, less the pounds 2,500 cash) to buy an annuity. So for a net investment of pounds 3,500 (your pounds 6,000, less the pounds 2,500 cash you took back) you will have pounds 7,500 in your fund to set aside for the annuity.
This money would typically buy a 60-year old man an annuity paying pounds 600 a year, says Quinton, so your pounds 3,500 investment is yielding pounds 600 gross a year, which is a gross return of 17 per cent per annum.Reuse content