What you need to know about pensions [AD]

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Some of the links in this post might be affiliate links.  This means that if you click on them and make a purchase I may receive a small amount of money at no additional cost to you.

This article is written in collaboration with PensionBee.

[AD] For many of us, retirement can feel like it is a long way off.  You might have another 20, 30 or even 40 years before you reach the current state retirement age.

But the thing is the earlier you start thinking about your retirement the better it will be.  At least from a financial standpoint.  Even better is that you might find yourself able to retire much earlier than expected.

One of the most common and tax-effective ways to do this is by paying into a pension.  In this article, I will aim to cover as many questions as possible on the topic, but feel free to comment below if I miss something.

What is a pension?

In its simplest form, a pension is pot of money that you and your employer contribute to during your working life with the view that you will draw money from it when you retire.

When the big day comes you will get a choice of drawing money from the pot, or trading that money with an insurance company in exchange for an annuity (definition below).

There are several tax benefits to paying into a pension, so for most it is the best way to build money ready for retirement.

Understanding the jargon

Like most things in the world of money, there are a few terms associated with pensions that we need to understand.  Here is a list of some of the common ones:

  • Annual allowance – the maximum amount that you can put into savings in a tax year that will qualify for tax relief.  In 2020-2021, this is £40,000.  This is across all your pensions savings, not per scheme.
  • Annuity – an insurance product.  You can use your retirement pot to pay for annuity which will guarantee you a certain level of income either for life or for a fixed period, depending on what you choose.
  • Cash balance pension – a pension arrangement with your employer where they promise you a pension pot of a specific amount.
  • Defined benefit pension (includes final salary and career average) – a pension scheme that pays out based on your salary and how long you were a member of your scheme.  Typically found in the public sector.
  • Defined contribution pension – the most common type of pension where you build up a pot based on contributions from yourself and your employer.
  • Lifetime allowance – the maximum value of pension savings that you can build up before incurring a tax charge.  For 2020/21, this stands at £1,073,100.
  • Market value reduction – a reduction to your pension pot that could apply if you want to cash in your with-profits policy before or after its maturity date.
  • State pension – a regular payment that you qualify for when you reach state pension age.  The amount you qualify for is dependent on your National Insurance record.
  • Tax-free lump sum – an amount of money you can take at retirement without paying tax.  Typically, it is up to 25% of your pension.

Tax relief on pensions

One of the many benefits of paying into a pension plan is the tax relief.  The amount that you will receive depends on the rate of income tax that you pay.

For basic rate payers, you receive 20% tax relief, higher rate payers get an additional 20% whereas top-rate payers can claim an additional 25%.

This doesn’t mean that you physically get the money back, instead it means that if, as a basic rate payer, you want to put in £100 to your pension, it will only cost you £80 of your take home pay.  The other £20 comes from the Government via tax relief.

What is auto-enrolment?

A couple of years back the law changed.  Before this, the company you work for might have offered you a pension scheme, you might have signed up and they might have made contributions on your behalf.

Now, however, your employer has to offer you a workplace pension.  Furthermore, they have to automatically enrol you in it and make contributions. There are some caveats to this such as you must be aged between 22 and state retirement age and earning more than £10,000 a year.

Under this system, you will make contributions of 5% or your salary, whilst your employer will contribute 3%. You can still opt-out of it, but the general recommendation is only to do this if you really cannot afford to make the minimum contributions. 

How much should I pay into my pension?

Most pensions that you are automatically enrolled into through your place of work, will have minimum contribution levels.  This means that you have to make those contributions to be involved in the scheme.

However, if you can afford it, then it is generally recommended that you pay in more due to the tax relief available.

There are also limits on the amount that you can pay in and still get the tax benefits.  These come in three forms:

  1. Earnings limit – you can only receive tax relief on amounts paid in up to your earnings in that year.
  2. Annual allowance – see above.
  3. Lifetime allowance – see above.

Does my employer pay in too?

Under the workplace pension scheme, the Government has set minimum levels that must be paid in by either you, your employer or both.

In addition to this, you employer must contribute an amount towards your minimum pension contributions.  The difference between what they pay and the minimum amount is paid for by you and Government tax relief.

I had a pension at an old job.  What can I do about it?

If you have changed jobs a few times, then it could be that you have several, forgotten about pensions.  It is a good idea to trace these so you can make some decisions about them going forwards.

You have three options here:

  1. Contact your old employers – speak to the HR department and provide them with your details including when you worked there and your National Insurance number.
  2. Use the Government’s pension tracing service – you can use this online, via telephone or in writing and they will search a database to find your old pension pots.
  3. Locate and transfer with PensionBee – if you are looking to combine and transfer your pensions, then PensionBee will work with you to find your old pensions and move them to their platform.

Choosing a fund

With defined contribution pensions, such as those offered in most work places, your employer will automatically invest your money through a provider.  They will pick a particular fund to invest it in, but you will likely have a choice of funds to pick from.

If you choose to move your pension to PensionBee, for example, they offer a choice of seven plans for your pension.  Each of these will invest your money into to a range of assets based on the objectives of your chosen plan.

You will need to research and potentially seek advice from a financial adviser, if you want to switch your pension plan.  As with any form of investment, your capital is at risk and your money could go down as well as up.

Can I pay into a Lifetime ISA too?

If you are under 40, then you can open a Lifetime ISA too.  You can use this to save for your first home, or for your retirement.

You can pay in up to £4,000 per year and the Government will top this up by 25% each year.  This is not meant to be instead of a pension but rather as a complementary product.

Final words

Yes they can seem confusing. And yes, retirement might feel like a long way off. But the general consensus is that paying into a pension is better done sooner rather than later, and with as much as you can afford.

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