It is a simple question with a deceptively complex answer.
The rules governing pensions are often tinkered with by the Chancellor of the day, though rarely retrospectively. Many people still hold pensions that were started decades ago under old regimes, and the rules governing them can differ greatly from the rules of today. This has resulted in a myriad of nuances and a situation where almost nothing can be said about pensions succinctly and without caveat.
With that in mind, this article attempts to explain the basics of a standard modern pension.
So, what is a pension?
In short, a pension is a pot of savings earmarked for your retirement.
The Government has a vested interest in persuading you to save for your retirement, so it incentivises this by offering numerous tax breaks for money held in pensions.
As such, pensions are probably the average person’s best chance to keep ‘the tax man’ away from their hard-earned cash.
How do I get money into a pension?
Anyone can contribute to a pension on your behalf, but contributions will usually come from you or your employer.
For every £1 of earned income that you put into a pension, HMRC will add another 25p to your contribution. (This is not unlimited, but the limits are too complex for this article).
Many employers will match the contributions of employees (at least up to a point), meaning you could potentially gain a further £1.25 for each £1 you contribute. Therefore, for the cost of £1, you end up with £2.50 in your pension.
It doesn’t stop there: if you are a higher or additional rate taxpayer, you can claim back a further 20p or 25p per £1 via your tax return, meaning that each £2.50 added to your pension could cost you as little as 75p! Some employers offer arrangements that can increase this uplift further still, but again they are too complex to cover here.
If you are a director shareholder of a limited company, then other tax breaks are available to help persuade you to extract profits via a pension.
What happens next?
Assuming you aren’t close to retirement, you should invest the cash within your pension to prevent its value being eroded over time by inflation. Another tax break is provided here, as investments held within a pension grow virtually tax free in a similar way to a stocks and shares ISA.
How do I get money out of a pension?
Once the money is in a pension, it will have to stay there (barring ill health) until you reach at least age 55 (and this looks set to increase in future, most likely to 10 years below state pension age).
When you do eventually take money from your pension, 25% can be taken completely tax free. The remaining 75% will be taxed as income and is usually paid and taxed via the PAYE system, much like an employee’s salary.
Whilst this may seem like a sting in the tail, in practice, the cumulative effects of the various tax incentives comfortably outweigh the tax paid in retirement, especially if you pay a lower rate of tax in retirement than you did when contributing to your pension.
So far you have had tax relief on the way in, tax free growth on investments, and 25% tax free on the way out, but the tax breaks don’t stop there: most pensions avoid inheritance tax on death, and if you die before age 75 then your beneficiaries won’t pay any tax on cash received from your pensions. Be sure to look out for our next article on pension death benefits, which will explain what you need to do to make the most of this.
If it looks like the Government are desperate to persuade you to save into a pension, then that is because they are. There are many reasons for this, some more cynical than others, but the benefits right now are undoubtedly worth exploiting.
If you want to discuss pensions further, then please contact Andy Hogarth in our Financial Planning team