What is a pension?
Let’s start with the absolute basic question of what exactly a pension is. A pension is a tax efficient way of saving for your retirement. You are allowed to pay a certain amount of money into this pension each year, and as a reward for saving into it, the government will give you some tax relief. You can put either the equivalent of your gross annual earnings or £50,000 (2013/2014 HMRC rules) per year into it, whichever is the lesser. So, for example, if you earn £30,000 a year, you could, in theory, make a gross contribution of £30,000 into your pension. If you earn £100,000 a year, you could make a maximum contribution of £50,000. If you do not work, you are allowed to pay in £3,600 per year.
If you are employed, you should be offered a pension scheme via your employer. In fact, it has now become law that everyone who is employed must be enrolled into a pension scheme, and depending on the size of the company that you work for, this will come into force between 2012 and 2018.
The money that you save into your pension can be invested for you in any number of ways depending on how comfortable you are with certain investments. The investments can grow in a tax advantageous environment until you get to retirement.
Why do I need one?
The basic state pension is currently £110.15 a week and that is if you qualify for a full state pension. Would you want to try and survive on that in retirement? I know that I wouldn’t. I often hear people say that their house is their pension, but I am not aware of supermarkets taking bricks in payment for food! The house that you live in cannot provide you with an income unless you downsize or take out further borrowing known as equity release and, even then, you would need to take a huge amount of equity from it to provide a fund large enough for a decent income. A pension does not have to be the only method of providing a retirement income if you have other investments and a rental property portfolio, but it should be a starting point and certainly not walked away from in a divorce settlement.
What is the benefit of having a pension?
When you make a payment into a pension you get what is known as tax relief. What that means in English is that the government rewards you for saving for your retirement by not making you pay tax on that part of your income.
So, using the previous example: you are working and earning £30,000 and have decided that you would like to pay £10,000 into a pension. You actually only need to make a contribution of £8,000 because the government will pay in £2,000, which is a refund of the tax that you have paid on your earnings.
If you earn enough to make you a higher rate tax payer and you are not making the contributions straight from your salary, you will need to fill out a tax return as you will get some more tax relief this way, known as higher rate tax relief. If you make the contributions straight from your salary via your employer, you will get the tax relief immediately and don’t need to do anything else.
The other important point to note is that you are only able to get tax relief on money that you have actually earned through employment or self-employment. Rental income, maintenance income and investment income are not valid for pension contributions.
The investments within the pension fund are sheltered from tax, which includes income tax (except 10% dividend tax), capital gains and, subject to certain rules, usually inheritance tax. This makes them a very useful vehicle for tax planning as long as you don’t need to access the capital before retirement.
When can I get my money out?
In return for the tax breaks that you get for saving into a pension, the government expect you to save this money for your retirement. You are allowed to access your pension fund from the age of 55. However, the longer you can leave that fund to grow, the better. Most people expect to retire in their mid to late 60s. You actually don’t ever have to take an income from your pension if you don’t need to, but for the vast majority of us, it will form an important part of our retirement savings and so we will need to take an income from it once we retire.
For further information and advice about pensions, please call me on 020 7125 0409
The Financial Conduct Authority does not regulate tax advice