What exactly is a ‘Pension’?
In its most simplistic terms, a Pension is a tax-efficient way to put money aside for your retirement to give your future self the life you will want to live.
Generally speaking, a pension is a tax-efficient way of investing money now, so you have an income in retirement. There are different types of pension plans available, depending on your circumstances. So here’s a quick overview of your options and how they work.
Remember, the value of a pension can go down as well as up and you may get back less than has been paid in.
Tax information is based on our current understanding of tax rules which may change, and tax treatment will depend on individual circumstances.
Types of pensions
Workplace pension
This is a pension that’s arranged by your employer.
There are 2 types of workplace pension:
- Defined contribution (sometimes referred to as a money purchase pension) – a pension that’s based on how much money has been paid into it. The money paid into the pension plan is invested by the pension provider. The amount available to you when you decide to access your pension savings depends on how much has been paid in, the charges taken out, and how well the investments have performed, so you could get back less than has been invested.
- Defined benefit – sometimes referred to as final salary pensions. The money you get back doesn’t depend on investments, but is based on your salary and how long you’ve worked for that employer
Auto-enrolment to a workplace pension plan was introduced in 2012. This means that if you’re between 22 and State Pension age, work in the UK and earn more than £10,000 a year, your employer must enrol you in a pension, although you can opt out. A defined contribution workplace pension is most commonly offered for auto-enrolment. With this, a percentage of your pay goes into the pension each payday and your employer adds money for you too. The current government guidelines on minimum contributions for a defined contribution workplace pension are that you would add 5% and your employer 3%, for a total of 8%.
There may be more benefit to paying extra into your workplace pension, rather than a personal pension plan.
Personal pension
There are many different types of personal pensions, including self-invested personal pensions (SIPPs), stakeholder pensions and individual personal pensions. A personal pension is also considered a defined contribution pension.
How regularly you pay in is usually up to you, although your pension provider may set a minimum amount you have to contribute as a single payment, or regularly. Other people, like your partner or employer, may also be able to contribute to your personal pension.
The investments available in a personal pension can vary, depending on the type of pension and the pension provider. For example, self-invested personal pensions usually give people access to a wider range of investments.
State pension
The State Pension is a regular payment that you have to claim from the government. To get a State Pension, you must first reach State Pension age, usually with at least 10 qualifying years on your National Insurance record. The amount you receive is also based on your National Insurance record and you’ll normally get the full amount if you have 35 or more qualifying years of contributions.
While the State Pension probably won’t be enough to support you on its own, it can be a useful addition to your retirement income.
Why pay into a pension
A pension is a way of investing for your retirement. Currently, you can normally access a defined contribution pension from age 55. Your pension plan can help you plan for the future, even though it is hard to know how long retirement will be.
While there are many ways to save and invest, below are some of the benefits you only get through a pension.
- You get tax relief on contributions. The government usually adds money to your pension in the form of tax relief, so if your pension scheme operates the ‘relief at source’ method of tax relief, the government will add £20 to your pension for every £80 you pay in personally. If you are a higher or additional rate tax payer, you may be able to claim the extra tax relief you’re entitled to through your self-assessment return. In some workplace pensions, your own contributions are paid by ‘exchanging’ part of your salary for a higher pension contribution than required from your employer. This means you’ll save the tax and National Insurance contributions on this money as it’ll be going into your pension instead.
- Employer contributions. With auto-enrolment fully in place, all employers must contribute to pension schemes on behalf of eligible employees. Check with your employer to see how much they’ll put in. As we mention above, some employers may also allow you to ‘sacrifice’ or ‘exchange’ part of your salary in return for pension contributions. In this way, both you and the employer may save on tax and National Insurance contributions. It’s important to consider that sacrificing or exchanging your salary would be a change of contract. It may not be suitable for everyone and if your employer offers this, you should contact them for further details.
How much you should pay in will depend on your individual circumstances, and the kind of lifestyle you want in retirement.
It’s never too early or too late to start putting money into a pension
The earlier you start thinking about what you’ll need for a comfortable retirement and where your money is going to come from, the more control you can have over that period of your life.
But it is never too late to start putting money into a pension, or finding ways to boost your pension contributions to help prepare you for retirement.
How to pay into a pension
For individual and workplace pensions, you can normally make regular and one-off payments. This will vary depending on both your provider and the type of pension you have, so check in advance that you can pay in the way you want to.
You can usually make payments through your employer too. Either contributions will come out of your salary, or your employer will pay into your pension themselves. Speak to your employer to see what they offer.
You can try our retirement planning tool to see how the amount you pay into your pensions could add up for retirement.
How you can receive money from your pension
Most pensions will have an age from which you can start taking money from your pension. For defined contribution pensions this is normally from age 55.
The government also has rules for when you can take your pension earlier than normal, for example if you become seriously ill or unable to work through ill health.
When the time comes to start taking money from your pension, you’ll need to decide how you want to do this.
- With a defined contribution pension, you can usually take up to 25% as a tax-free lump sum. There are a number of ways to access the remaining pension benefits, such as: a cash lump sum, a guaranteed income for life (annuity), flexible income (drawdown) or a combination of options.
- With a defined benefits pension, you may be able to take some of its value as a tax-free lump sum, but this will depend on the rules of your scheme. The rest of the money will be paid to you as a guaranteed income for the rest of your life.
- Different ways of taking your money have different levels of risk and security and potentially different tax implications too. As with all retirement decisions, it’s worth getting guidance or advice on what’s best for you.
Don’t leave it too late!
Planning for your pension is one of the most important financial decisions you may make. Helping you make those right choices, to ensure you give yourself the lifestyle you want in later life while ensuring you can still enjoy your life today, is what we do at Blackfords – and the first ‘discovery’ meeting is free and with no obligation at all.
Since 2004, we have been providing independent financial advice to individuals, families and business owners on our beautiful island, the Isle of Man.
From investments to pensions, mortgages to life and family protection, and whether you are looking to start your financial plan or gain an independent review of your existing plans, Blackfords are here for you in Douglas, Ramsey and Port Erin and offer a free 1 hour no obligation consultation.