All you need to know about pension
A pension is a good way to save for your future and ensure you’re set up to have money in retirement – and most people know that. So why are pensions a big switch off for many?
One reason could be that they might not seem a priority. The future can seem a long way away when you’re struggling to make ends meet in the here and now.
They can also be difficult to understand. There are so many different pension options and jargon to get your head around, it can sometimes feel overwhelming and complicated.
If these seem like reasons you’ve been neglecting your pension, a little guidance could be just what you need.
Is a pension really worth it?
A key plus of a pension plan is the tax relief, which comes in two forms depending on whether you’re a basic-rate or higher-rate taxpayer.
You get some tax back on the money you put into a pension, while gains from the investments you make with that cash are largely tax-free.
What tax relief do I get?
If you pay the money into your pension yourself, or if it is taken by your employer from your pay packet, you automatically get 20% tax back from the Government as an additional deposit into your pension pot.
If you are a higher-rate taxpayer you can claim an additional 20%, while top-rate taxpayers can claim an additional 25%. If you are part of a workplace pension, you may not need to reclaim any tax if your employer simply deducts less tax from your pay packet.
However, if you don’t reclaim, it won’t be paid. Therefore, it is important to check if you are in a higher tax bracket.
If your employer puts the money straight in from your pre-tax pay then it’s never taxed in the first place, so you still win.
How does the tax relief work?
If you get 20% tax relief, it doesn’t mean you get 20% back of what you contribute.
Instead, the taxman works out your earnings on your contribution amount before tax was deducted. You then get back the difference between your contribution and your pre-tax earnings.
So, when a basic 20% rate taxpayer invests £80 of their take-home pay in a pension, they’d have earned £100 before tax to come out with £80 (20% of £100 is £20, leaving £80). In that example, the tax relief is £20.
The graph below illustrates the tax boost.
How much should I put in a pension?
With auto-enrolment pensions, there are minimum contribution levels. But if you can you afford it; you really should be contributing more.
Before starting, it’s worth noting those in debt, especially at high rates of interest, should consider whether it’d be better to get rid of that before starting a pension. Plus, a pension’s only one form of retirement planning. Combining it with other methods is often a good plan.
If you opt for a pension, the simple answer of how much to put in is as much as possible, as early as possible. There are some rules for comfortable retirement:
- Don’t delay.The sooner you contribute, the longer your money has to grow. The compounding effect – where the cash your investment earns can, itself, attract additional earnings – makes a massive difference.
- Increase payments.It’s important to put away a constant proportion of your earnings. As your pay increases, make sure your contributions increase proportionately, or you’ll fall behind.
- Use the ‘pay rise trick’.Most people will be unable to contribute enough at the beginning. So, start with whatever you can, but each time you get a pay rise, put a quarter of it each month into your pension. Then you’ll be basking in the glory of more money, without getting used to spending the cash destined for your pension.
How much can I put in a pension?
There’s technically no limit as to how much you can put in a pension. But there are limits on how much tax relief you’ll get for doing so, and there are three different limits you need to be aware of:
- An earnings limit.You get tax relief on contributions up to your annual earnings. Imagine you earned £20,000 each year, but had £30,000 in savings, and decided one day to put all your savings into a pension. In this situation, you would only earn tax relief on the first £20,000 of your contributions.
- An annual limit. This limit only applies to higher earners. You can only get tax relief up to your current annual allowance, made up of the current year’s allowance (currently £40,000) and any unused allowance from the previous three tax years.
For many years, your company may have set up and contributed to a workplace pension. But not all companies have offered workplace pension schemes and auto-enrolment is designed to address this.
The auto-enrolment rules mean that if you’re an employee, your employer will be forced to offer you a pension scheme. From 2018 all employers by law had to contribute to their employees’ pensions. And from 6 April 2019, the minimum contribution level has increased to 3% from employers with a combined minimum total of 8%.
You have the option to say ‘no’ to auto-enrolment if you don’t want to join. But it’s an opt-out rather than an opt-in scheme, so if you do nothing, you’ll be opted in.
What happens when I retire?
Once the money is in a pension, it can’t be withdrawn willy-nilly. It must stay there until you’re at least 55. (There are some extenuating circumstances where you can withdraw the money before 55). At that point, you can take 25% of it as a tax-free lump sum, with the rest ideally providing an income for the rest of your life…
If you get approached before you’re 55, it’s a scam known as pension liberation. These scams are so damaging the government banned cold calling about pensions in January 2019. Firms ignoring this could be fined £500,000.
When your regular income stops… it’s decision time. Ideally, start preparing a few years beforehand.
Provided you’re over 55, you’ll be able to take as much as you like, when you like – though drawdowns above the tax-free 25% will be taxed at your marginal rate – so 20% if you’re a basic-rate taxpayer, 40% or 45% if you’re a higher or additional-rate payer, or the amount you’ve taken from your pension pushes you into that rate.
Having pension savings is not only a good way to save money for retirement, but it can also help provide security for your loved ones too.
For example, if you die before the age of 75, your pension pot can be passed on tax free to a nominated beneficiary. However, if you pass away after 75, and your beneficiary wants a lump sum they will have to pay 45% tax – this money will be taxed at the beneficiary’s income tax rate.
Do you still have questions?
In Outsourced ACC we have a wide range of experience for over 20 years. Get in touch with our team on 0208 249 6007 to find out more about how they can help you.