An introduction to pensions

Understanding pensions is key to being able to enjoy your retirement, so you have enough money to cover everything you’d like to do in your spare time.

What is a pension?

A pension is a retirement plan that provides a tax-efficient source of income which you receive later in your life, so you can pay for your outgoings once you have stopped working.

How do pensions work?

For most people, your pension will come from three different sources; the state pension, your workplace pension and then any private pensions. You build up your pension ‘pots’ throughout the years that you are working, and when you reach retirement age, you can start to claim this money back to give yourself an income.

Separately to pensions, people often will also use savings or other investments to boost their spending during their retirement. This would include cash savings, or selling a property and downsizing, but these are not classed as a pension.

Why are pensions different to money in a savings account?

Whilst you may still use cash savings in a standard savings account to support you when you have retired, a pension is different. A pension comes with different benefits, such as tax relief, and you can’t access a pension until a certain age. Pensions are also often invested, and this investment is managed by your pension provider, so you should see much higher returns than cash in a savings account..

Different types of pensions

There are 3 main types of pensions in the UK. Each type of pension is different and it's important to know the difference between them before starting to plan your retirement;

  • State pension  
  • Workplace pension  
  • Private or personal pension

State pension

A state pension is a type of pension you can claim from the government once you’ve reached the state pension age. The state pension age rose in 2020 to 66, and the government have set a timetable for continued rises in future.

The state pension will currently give you a maximum of £185.15 per week, but not everybody will get the full amount. The amount you receive from your state pension depends on the number of qualifying years, e.g. the number of years you’ve paid national insurance.

Workplace pensions

In 2008, it became law in the UK that employers must automatically enrol their employees onto a workplace pension, and employees can opt-out of the pension if they want to.

Workplace pensions are organised by your employer, who most commonly choose a provider to run the pension scheme for them. When you start a new job, you’ll likely get sent a big pack of jargon from a pension provider, but it is important you keep hold of those documents, so you can have all your pension fund details to hand.

You can choose how much of your salary to contribute to your workplace pension. The money then gets taken automatically from your payslip. Your company will then match your contribution (up to a capped limit set by them). The government also then contributes to your pension in the form of tax relief. The government currently top up your pension contribution by 20% if you are on a basic tax rate. What this means is that some of the money from your monthly pay that would have gone to the government in the form of tax goes towards your pension instead.

You earn £30,000 per year.
Your monthly workplace pension contributions: 4% = £100
Governments monthly contribution = 20% of your contribution = £25
Employer matches total monthly contribution = £125
Total added to your pension pot each month = £250

Personal or private pensions

Personal pensions are a pension you set up yourself and are often used by the self-employed or by those who want to save more than their workplace pension. As with an employee pension, you benefit from tax relief on your contributions.

As with workplace pensions, the money that you put into your personal pension is invested into financial products by the pension provider you choose to go with. It’s up to you to choose how you want to pay into your pension, whether that’s by monthly payments or lump sums.

Do I need a private pension if I have a workplace pension?

What is a pension fund?

A pension fund is the portfolio of assets that your pension contributions are being invested in. Some funds are more high risk than others, meaning based on past performance, you may see a higher return but are also at a higher chance of seeing the value of your investment decrease, and some funds may be lower risk, for those who would prefer to potentially see less returns but are less at risk of seeing a decrease in value.

For workplace pensions, people often just opt in for their schemes default pension fund. For personal pensions, it would be worth using a financial adviser (like us…cheeky plug) to help assess your attitude to risk, and which pension fund would be a good option for you.

How does tax work with pensions?

Nobody likes paying tax, and people often try to find ways to reduce their tax. Paying into a pension is a really good way to claim some tax relief. There are two ways to claim tax relief on your pension.

The first is called ‘relief at source’. What this means is that once you’ve paid your pension provider your contribution, if you’re on the basic tax rate, your pension provider will claim 20% tax relief directly from the government, and they add this to your pension pot. Personal/private pensions always used the relief at source method.

The second is through a method called ‘net pay’. This is where your employer deducts your pension contributions from your pay before your pay is taxed, meaning you pay less income tax, as your income tax would be based on less money.  This method means you don’t get any tax relief reimbursed directly into your pension, but it means you get to take home more money each month by paying less tax overall.

For your workplace pension, your employer will choose which method they want to use.

Whilst there isn’t a limit on how much you can save or contribute to your pensions each year, there is a £40,000 per year limit on tax relief for most people. For example, if you came into a lot of money such as £100,000 and wanted to put all of that into your pension, you would only be able to claim tax relief on the first £40,000 unless you meet other specific criteria.

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