You may not get your kicks learning about pensions (few do), but there’s no denying they’re important.
A good pension can mean the difference between a comfortable retirement and scraping to get by. This guide will help you understand how pensions work and how much to save.
A pension is essentially a way of saving money for retirement – in fact, it’s a financial product that’s specifically designed for this purpose. A pension can give you a source of income when you’re no longer working.
Pensions can have several advantages over other financial products (such as savings accounts) when you’re putting away money for retirement:
You can get tax back on pension contributions worth up to 100% of your annual salary. We look at tax relief in more detail later.
Pensions won’t affect your application for unemployment benefits. This is because they’re not counted as part of your wealth, while money in a savings account usually is.
Pensions are protected if you go bankrupt. You may be forced to give away your savings if you go bankrupt, but your pension will be protected.
Of course, other financial products may have benefits that pensions don’t, such as higher interest rates or earlier access. But there’s nothing to stop you saving for retirement with both a pension and another product, such as an ISA or investment.
The state pension is paid for by the government. If you’re eligible, you can claim the state pension when you reach the state pension age.
Importantly, a new state pension was introduced in 2016. This is what you can get if you’re a man born on/after 6 April 1951 or a woman born on/after 6 April 1953.
To get the state pension, you’ll need to pay national insurance contributions (or get national insurance credits, e.g. if you’re unemployed or sick) for at least 10 years. It doesn’t have to be 10 years in a row though.
On the new state pension, you can get up to £164.35 per week. The amount you’ll get will depend on the national insurance contributions you’ve made – you may need a record of up to 35 years’ worth of national insurance contributions to get the full £164.35.
You’re probably thinking that the state pension isn’t much to live on. This is why it’s important to boost your retirement income with a workplace or personal pension if you can.
A workplace pension – also called an ‘occupational’ or ‘company’ pension – is arranged by your employer.
Both you and your employer will make contributions. This is usually a percentage of your earnings between £5,876 and £45,000 a year (before tax), and there's a minimum percentage you and your employer must contribute between you.
Currently, the minimum you and your employer must contribute to your workplace pension is 5%. Your employer must pay at least 2% and you must pay at least 3% – but this is due to change to 3% and 5% respectively in 2019.
With some pension schemes, your employer can pay more and you can pay less – as long as it adds up to the minimum percentage you need to contribute between you.
Automatic enrolment means your employer must put you on their pension scheme without you having to ask. This applies to workers who earn more than £10,000 per year and are between 22 and the state pension age.
There are a few exceptions, such as if you’re in a limited liability partnership. But in most cases, you can still ask to join your workplace pension and your employer won’t be allowed to refuse.
Your employer must tell you:
When they added you to their pension scheme
The type of pension scheme and who runs it
How much you and they need to contribute
How to opt out of the scheme
What tax relief you’ll get
Note that employers don’t have to enrol you until your probation period ends, as long as this is no more than three months.
Worked at multiple companies? Chances are you have more than one workplace pension sitting around with money in it.
Most pension schemes must send you a statement each year. But if they’ve lost contact with you and you want to track down your pension, you can try:
Contacting the pension provider directly
Talking to your former employer
Using the Pension Tracing service
If you have several pensions, you could look into combining them. This may make it easier to keep track of your money – although there can be risks and costs involved.
A personal pension is a common option for people who don’t have a workplace pension, for example because they’re self-employed. But employees may also choose to get a personal pension scheme, as this can give them more control over how their money is invested.
It’s usually a good idea to speak to an independent financial advisor if you want a personal pension. You’ll need to pay them a fee, but it can be worth it to find the right scheme.
Defined contribution vs defined benefit
When it comes to workplace and personal pensions, there are many different types – but they generally fall into two main categories:
A defined contribution pension allows you to build up a ‘pot’ of money. When you retire, you can withdraw from this pot to help cover your living costs (or anything else you want to spend it on).
The overall amount will depend on how much you – and potentially your employer – put into the scheme. You’ll also need to take into account interest, investment gains and any charges.
Once you’ve retired, you can choose when and what to take out of the pension pot. Just be aware, this can affect how you’re taxed when taking your pension.
A defined benefit pension gives you a set, guaranteed income for life once you reach the scheme’s retirement age. The amount you get is usually based on your salary and how long you’ve been on the scheme.
For example, one type of defined benefit pension is a final salary scheme. This pays an amount based on how much you’re earning when you retire or leave the scheme. Another type is a career-average scheme, which bases payouts on your average salary.
Defined benefit pensions are becoming less common. But you’re more likely to get one from your employer if you work in the public sector.
Basic rate (20%) taxpayers
You get tax relief on pension contributions up to your total yearly salary. Of course, you’re unlikely to put your entire salary into a pension since you need something to live on. But in some cases, it’s possible to put savings into your pension – so this is why there’s a limit.
Most employers and pension providers will arrange for you to automatically get 20% tax relief. This means you get income tax back on your pension contributions.
Higher rate (40%) taxpayers
You can get 40% tax relief on up to £40,000 per year and carry any unused allowance over for the next three years. Remember that your employer’s contributions count towards this allowance.
Your employer may arrange for this tax relief to be applied automatically. Otherwise, you may find your tax provider only claims the first 20% tax relief for you (this is called relief at source). But you can still claim the remaining tax relief on your self-assessment tax return or by contacting HMRC.
Additional rate (45%) taxpayers
You can get 45% tax relief on the same allowance as higher rate taxpayers. However, your £40,000 allowance will be reduced if your total income (including pension contributions) goes over £150,000 in a year. For every £2 earned over £150,000, the allowance reduces by £1. Note that people who earn under £110,000 (excluding pension contributions) are exempt from this rule.
There is also lifetime limit: you won’t get any more tax relief if your total pension savings (including gains and interest) go over £1,030,000.
Tax relief on pensions in Scotland
If you pay income tax at 19%, your pension provider will claim tax relief for you at 20% and you don’t need to pay the difference. If you pay income tax at 21%, you can claim tax relief for 20% and you’ll get the remaining 1% through your pay.
If you’re a basic rate (20%), higher rate (41%) or top rate (46%) taxpayer, you can claim tax relief at the highest rate of income tax you pay.
Many employers use salary sacrifice to take your contributions out of your pre-tax pay and put them straight into your pension scheme. One of the advantages of this is that tax relief is applied automatically.
Because of this, you’ll notice your contributions boost your pension more than they make a dent in your paypacket.
Here’s an example: say you pay tax at 20% – this means when you earn £100, you’ll pay £20 to the government, leaving you with £80. But if you sacrifice that £80 to your pension, you’ll get the £20 back. So, you’ll see £80 less in your paypacket, but £100 more in your pension.
Bear in mind, this means higher rate taxpayers can give up less of their paypacket than basic rate taxpayers to achieve the same pension savings.
Here’s an example for comparison: say you pay tax at 40% – this means when you earn £100, you’ll pay £40 to the government, leaving you with £60. But if you sacrifice that £60 to your pension, you’ll get the £40 back. So, you’ll see £60 less in your paypacket, but £100 more in your pension.
If you look at the examples side by side, you’ll notice both taxpayers end up with £100 more in their pension – yet the higher rate taxpayer only see £60 less in their packet, while the basic rate taxpayer sees £80 less.
Here are some things to consider when working out how much to save in your pension:
When you want to retire. The earlier you want to retire, the larger your pension should be. For example, let’s assume you’ll live to 80: if you retire at 65 you’ll need to live off your pension for 15 years, but if you retire at 50 you’ll need to live off it for twice as long.
Your living costs in retirement. This is a tricky one to predict. Currently, the average retired household spends £21,770 a year – but this may well increase with inflation.
Other sources of income. Your may have other savings or investments to draw upon in retirement. A common way to get cash in later life is to sell up your home and buy a cheaper one – but remember, there is a risk that your property’s value will decrease beforehand.
Tax relief. Getting tax back on your pension contributions can make a big difference, so make sure to claim it and factor it into your estimations.
What you’ll pay in tax when taking your pension. Did tax relief sound too good to be true? In some ways it is, because once you retire and start taking an income from your pension, you’ll be taxed on it. But there’s good news: the first 25% is tax-free. The remaining 75% will be taxed at a rate that’s based on your income during retirement.
Your employer’s contributions (if you have a workplace pension). Don’t forget that your employer’s contributions can give your pension pot a sizable boost. What’s more, employers will often contribute more when you do – it’s worth checking out what they offer.
Interest and gains (if you have a defined contribution scheme). How well your scheme performs will affect the overall amount in your pension pot. So, it’s important to review your pension regularly to ensure it’s still the best choice. You might want to consult an independent financial advisor – especially if you have (or want) a personal pension.
It’s also worth knowing that compound interest means that the earlier you start saving into your pension, the more interest you should earn overall.
Charges (if you have a defined contribution scheme). Any charges will take away from your pension pot, so it’s important to include these in your calculations.
With a defined benefit pension, you know how much income you’ll have when you retire – but you should still consider if it’s enough. If not, you may want to look into topping it up or making additional savings.
Finally, remember to balance your future needs with your current needs. For example, before bumping up your pension contributions, consider if that money would be better spent paying off high-interest debt first.
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