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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.

However, some people continue to build up a small entitlement to the additional State Pension as well. You will get an additional State Pension for 2011/12, if you contributed to a contracted-out personal pension and earned less than £14,400 in 2011/12.

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

The rules for contracting out of the additional State Pension will change in 2012. The changes mean that contracting out will not be possible through:

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

If you are contracted out through one of these schemes on 6 April 2012, you will automatically be brought back into the additional State Pension. You will begin to build up additional State Pension from this time. Download ‘Abolition of contracting out on a defined contribution basis' to find out more.

To find out what a money purchase and a defined contribution pension is, see ‘What happens to your company pension when you die’.

• Download 'Abolition of contracting out factsheet' (PDF, 116K)

• Help with PDF files

• What happens to your company pension when you die

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

• Additional State Pension

• Who to contact at The Pension Service