How does a pension work?
Pensions are tax efficient savings products that are designed to help you save money for your retirement and ultimately provide an income when you come to retire.
What type of pension do I have?
Aside from the state pension, there are two main types of pensions available: defined benefit or defined contribution. Each has its benefits and drawbacks depending on your personal circumstances, as highlighted below. This article will predominantly focus on defined contribution pension plans which are much more common nowadays and can be set up privately, unlike defined benefit schemes which must be set up through an employer.
What is a defined benefit pension?
Defined benefit pensions (sometimes called final salary pensions or career average revalued earnings pensions) share one common and highly valuable characteristic - at retirement they promise to pay you a secure income for life, often with some form of annual uplift.
With a final salary pension the amount of pension you receive depends on your salary at the time of leaving employment and the length of time you worked for the employer. The difference with a career average revalued earnings (CARE) pension is the amount of pension received depends on your average salary over the period of employment, not just your final salary at the time of leaving employment.
These are considered the gold standard for pensions but have become increasingly rare. This is due to the financial burden of meeting the pension liabilities falling on the employer, which is largely dependent on the performance of investment markets.
The employer is duty bound to pay each member’s pension, which is a tall order given an ageing population, and is one of the main reasons why these pensions are rarer than they once were.
What is a defined contribution pension?
A defined contribution pension (also known as a money purchase scheme) can be a private or workplace pension, whereby you and/or your employer contributes towards your retirement fund which is typically invested. The amount you receive from your pension depends on the amount of money you have accumulated in your pension pot when you retire. The investment performance of these pension funds therefore becomes much more important to the individual than in a defined benefit scheme.
Since the introduction of auto-enrolment in 2012, anyone in employment is likely to have been enrolled into a workplace pension, with the government aiming to get more people actively saving for retirement.
A workplace pension is usually simply another form of a defined contribution pension designed for multiple employees to use for their pension savings. Each employee will be set up with an individual pension plan with the same pension provider.
The premise of a workplace pension plan remains the same as a private pension plan - the amount contributed by you (and your employer) and the performance of the underlying funds is directly linked to the amount of money you will receive at retirement.
What are the benefits of having a pension?
Whilst there may be other ways to save and invest and a pension typically cannot be accessed until at least age 55 (rising to 57 in 2028), a pension provides valuable benefits when it comes to putting money away for retirement.
On any personal contributions made into a pension plan, the government will add 20% in tax relief up to certain limits (see below). If you are a higher or additional rate taxpayer, you can claim further tax relief via your self-assessment tax return. For every £100 contribution into a pension plan, this will effectively ‘cost’ £80 for a basic rate taxpayer, £60 for a higher rate taxpayer and £55 for an additional rate taxpayer.
A further benefit of having a pension is that the underlying investments are free from capital gains tax and income tax. This means you don’t have to pay capital gains tax on any profits made, and any investment income such as dividends is free from income tax.
Lastly, pensions typically fall outside of your estate for inheritance tax purposes, hence can potentially be a useful tool for passing on wealth that is surplus to your own needs.
How much can I put into a pension each year?
While there is no limit on how much can be saved into a pension each tax year, there is a limit on how much can be saved (while still benefiting from tax relief) before a tax charge might apply. This is known as the annual allowance.
For defined contribution pensions, this limit is based on the total of your personal contributions (plus any tax relief received), any employer contributions and any contributions made by a third party on your behalf.
For defined benefit pensions, the ‘contribution’ amount for a tax year involves a calculation based on the effective capital value increase of benefits over the tax year. Your pension administrator should be able to provide this information on request.
For most people the annual allowance is currently £60,000 per tax year. For personal contributions, you can however only receive tax relief on contributions up to 100% of your ’net relevant earnings’ for a tax year. Net relevant earnings are typically all types of earned income (total employment income including bonuses/commission plus taxable benefits in kind for the employed and trading profits for the self-employed). It is important to note this doesn’t include pension income, dividends (including for business owners) and most types of rental income.
Therefore, if your net relevant earnings are lower than £60,000 for a tax year, your personal pension contributions (including any tax relief) will be limited to this amount. Employer contributions are not restricted by your net relevant earnings, however they do still count towards your annual allowance from a tax relief perspective.
If you are a high earner with ’threshold income’ above £200,000 and ‘adjusted income’ of over £260,000 (see below for definitions), your annual allowance may be ‘tapered’ down to as low as £10,000 per tax year. This is referred to as the tapered annual allowance.
- Threshold income – All sources of taxable income for a tax year plus any employment income given up for pension contributions (i.e. salary sacrifice) under an arrangement since 9th July 2015, less the gross amount of any personal pension contributions and less any taxable lump sum pension death benefits received.
- Adjusted income – All sources of taxable income for a tax year plus the value of all employer pension contributions (including via salary sacrifice) less any taxable lump sum pension death benefits received.
Note that for both calculations ‘taxable income’ is before any deductions for pension contributions have been made. Therefore, any employee contributions taken from gross pay under a ‘net pay’ arrangement should be added back in.
If you have ‘flexibly accessed’ your pension (i.e. taken more than the 25% tax-free entitlement through flexible retirement income or a lump sum), your annual allowance will be limited to £10,000. This is known as the money purchase annual allowance.
Can I make use of any unused annual allowance?
It may be possible to carry forward any unused annual allowance from the previous three tax years, but there are certain rules you must adhere to. Again, any personal contributions will be restricted by your net relevant earnings within a tax year.
In order to make use of any unused allowance from the previous three tax years, you must first use up any annual allowance from the current tax year.
You must have also been a member of a registered pension scheme during the course of the tax years in question.
What happens if I exceed the annual allowance?
If you have paid more than the annual allowance into a pension within a tax year (and have no available carry forward allowance), you will not receive tax relief on contributions in excess of the limit, and you will be subject to an annual allowance tax charge. Effectively, the amount in excess of the annual allowance will be taxed as income at your highest rate.
What is the lifetime allowance?
The government not only restricts the amount you can tax-efficiently put into your pension each year, it also limits the amount you can have in your personal pension pot overall before a tax charge may be applied. This is known as the lifetime allowance.
On 15th March 2023 the Chancellor announced the abolition of the lifetime allowance from 6th April 2024 onwards.
Pension savers who access their pension benefits in the 2023/24 tax year will still have their benefits assessed against the lifetime allowance. However, no excess tax charge will be applied to any retiree who has benefits exceeding the lifetime limit of £1,073,100 and keeps the excess funds in their pension plan.
When can I take my pension?
The normal minimum pension age is the earliest age most people can start taking money from their pensions. It is currently set at 55 years old, but this is due to increase to age 57 from 6th April 2028, unless you have a protected pension age. If you are in ill-health, you may be able to access your pension before the normal minimum pension age.
Note: for Defined Benefit pensions the age at which you can take your pension will be scheme specific, although you may be able to opt for ‘early’ or ‘late’ retirement.
How do I take money from my pension?
Once you have reached normal minimum pension age, you have a choice on how to draw upon your pension pot. These include taking a flexible income (typically known as ‘drawdown’), buying a guaranteed income for life (an annuity), or taking lump sums.
With the introduction of pension freedoms in 2015, there is a lot more flexibility when drawing from a defined contribution pension plan and a combination of the above options can be used. The full value of a pension plan can even be drawn as a one-off lump sum; however, this may result in a significant tax liability and not be a wise strategy.
As noted above, defined benefit pensions typically have a scheme specific age at which benefits can be taken, known as the Normal Retirement Age (NRA). Members of such schemes will receive an annual pension from the NRA and potentially a one-off tax-free lump sum. Members may also have the option of ‘exchanging’ some of the annual pension for a tax-free lump sum.
Do I have to pay tax on pension income?
With a defined contribution pension plan, you are able to take the first 25% tax-free, with the remaining 75% subject to your marginal rate of income tax. You can either take the full 25% as a lump sum, or it can be drawn in stages, depending on what you want to do with the remainder of your pension.
With a defined benefit pension plan, you may be able to take a one-off tax-free lump sum when you start taking benefits (potentially in exchange for a reduced annual pension). Any annual pension will however be subject to your marginal rate of income tax.
It is typically a good idea to speak to a financial adviser before you make any key decisions regarding drawing money from any type of pension plan.
How do I open a pension?
Since 2012, employers in the UK have been gradually required to comply with ‘Auto Enrolment’ rules and provide a workplace pension scheme for all eligible employees. Therefore, for anyone in employment since this point, it is likely you will have a ‘workplace’ or ‘occupational’ pension plan.
Whether you have a workplace pension or not, you are able to set up a ‘personal’ or ‘private’ pension. If you decide to open a personal pension plan, it is up to you to choose the pension provider, the level of any ongoing contributions and what underlying investments the pension is invested in.
How can The Private Office help?
It’s important to know that defined contribution pensions are usually invested in underlying investments that carry differing degrees of risk, such as company shares, or government bonds. The value of your pension can therefore go down as well as up, and you could get back less than you put into a pension.
It is crucial to ensure that your pension is invested in appropriate underlying investments that are in line with (1) your attitude to investment risk and (2) how far away from retirement you are.
Therefore, whether you are approaching retirement or just starting your pension saving journey, having a suitable plan and strategy in place is key to achieving your retirement objectives.
If you would like to find out more about how we can help you with your pension needs, please do get in touch to arrange a free initial consultation.
This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.
The information in this article is based on current laws and regulations which are subject to change as at future legislations.
A pension is a long-term investment. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.
The Financial Conduct Authority (FCA) does not regulate tax advice.