Getting your head around pensions can be confusing and scary. Here we’ll start with the basics, helping you decide which options suit you best.
What is a pension?
Put simply, a pension is tax efficient way to save for your retirement. When you retire, you can draw money from your pot, or sell your pension in return for regular income for the rest of your life (also known as an ‘annuity’). Generally, you can access the money in your pension pot from the age of 55.
Pensions have a number of important advantages over other savings options, which encourage your contributions to grow over your career. These include:
- Tax relief
- Top ups from employers
- Tax free lump sum when you retire
There are a few different types of pension:
- Workplace pension
- Personal pension
- State Pension
Let us take you through each of these in a bit more detail.
Most of us have our first encounter with pensions at work. Many employers offer company pension schemes, and as of April 2017 they are required to do so by law. A company pension scheme can be one of the simplest ways to put money away for retirement, as it’s easy and you’ll be auto-enrolled without having to do anything.
One of the biggest benefits of company pension schemes is that the company will often match your contributions. While this isn’t going into your monthly pay packet, you can think of this as a pay rise effectively! If you put 5% of your salary into the pension pot, they might match that, giving you a total pot of 10% of your salary each year you pay money in.
Within the workplace, pensions can come in different forms. An important distinction to make initially is whether the pension in question is a final salary, or a money purchase pension.
Final salary pensions
These are largely funded by employers, with employees paying in sometimes. With a final salary pension, what it means is you’ll get a percentage of your final salary before retirement – or when you leave – as a regular income. The percentage is calculated based on the years you’ve worked at a company. For instance you might be offered a rate of 1/50th of your salary for every year you worked at a company – which could be 25 years. That’s 25/50ths, or half of your final salary with the company.
Money purchase pensions (defined contribution schemes)
These save money into a pension pot under an agreement with your employer. When it comes to withdrawing, you can take the cash out or swapped for an annuity – simply an income for the rest of your life.
What is auto-enrolment?Auto-enrolment is designed to address the problem of people who don’t contribute to a pension. The auto-enrolment rules mean employers are legally obliged to offer employees a pension scheme. If you do nothing, you’ll be opted in – hence the name. You can, however, choose to opt out if you wish.
A personal pension is one you set up yourself. You can choose to pay it yourself, or hire someone to manage the pension for you. You can get great tax breaks on a personal pension too, with the Government putting in 25% or more of your contributions. Ideally, after a long period of time, your money will have had chance to grow!
Typically, by the age of 55, you’ll be able to withdraw 25% of your pension pot tax free. Anything more than this is subject to regular income tax. Like workplace pensions, you’ll also have the option to purchase an annuity.
Most UK citizens get some State Pension. The State Pension is a secured income for life, which is increased each year at the rate of inflation. The State Pension comes from National Insurance (NI) contributions, which you’ll make throughout your life. To be eligible for the State Pension, you’ll need to have made 35 years worth of NI contributions.
Anyone working in the UK who is over 16, earning more than £153 a week, is required to make NI contributions. Doing this for 35 years means you’ll be entitled to a full state pension – currently a maximum weekly payment of £119.30. For those who’ve missed NI payments, it is possible to make voluntary ‘catch-up’ payments to get back on track.
Who holds my pension money?
The Government has its own scheme called the National Employment Savings Trust (NEST), which many employers join. Alternatively, your employer may choose another company which manages your investments. You’ll be able to decide on the levels of risk you’re willing to take with them.
What happens with the money when I retire?
As soon as you begin contributing to a pension, it can’t be withdrawn easily. It must stay in the pension pot until the age of 55. Then you can withdraw 25% as a tax-free lump sum. The rest should ideally provide you with enough income for the rest of your life.
It’s up to you to begin planning as you approach retirement age. When your regular income stops, you need to make decisions about how much money to withdraw and how much you’ll be living on.Back to top
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Charlie is a publisher at Finder. He specialises in Banking and Investments products, including banking apps, current accounts, share dealing platforms and stocks and shares ISAs. Charlie has a first-class degree from the London School of Economics, and in his spare time enjoys long walks on the beach.