Your pension questions answered
No one really wants to think about getting old. We get it. But even worse than thinking about getting old is thinking about getting old and struggling to make ends meet. It is worth understanding how you can make sure your golden years really are golden.
Why do I need a pension?
Unless you plan on working until you’re 100, you need to have some sort of income when you retire. The retirement age varies between countries but it’s likely you’ll stop working in your 60s (66 for men and women in the UK from October 2020). You’ll need to survive on something other than fresh air.
The state will likely pay you a pension if you’re eligible, but it’s a good idea to put away some of your own income on a regular basis throughout your career as soon as you’re able to in order to supplement what the government gives you.
What are the tax benefits of saving through a pension?
Most people are able to contribute a maximum of £40,000 a year to their pension (this is for the tax year 2019/2020). You’ll enjoy tax relief from the government if your contributions are less than your earnings, and if you’re under the age of 75.
Tax relief is paid at the highest rate of income tax you pay and is essentially the government’s way of rewarding you for saving. If, for example, you’re a basic-rate taxpayer, the government will add 20% to your pension. So if you put £1,000 into your pension, it’ll only cost you £800 because the government will add £200 (the amount it would have taken in tax from £1,000 of your earnings).
You also don’t pay capital gains tax on the money you put in your pension pot.
However keep in mind that treatment could change in the future and is based on individual circumstances.
What are the options?
Aside from your state pension, you can contribute to private pensions through your workplace and/or a personal pension. There are no limits to how many pensions you can have (although there are limits to the tax benefit you’ll get on the contributions).
As the name suggests, workplace pensions are arranged by your employer. They generally deduct your pension contribution directly from your salary and also make a contribution themselves.
Since February 2018, all employers are required by law to offer workplace pensions to employees who are over the age of 22 and earn more than £10,000 a year. This is called automatic enrolment (find out more about the topic in this article).
You are able to opt out of automatic enrolment but you should be aware of the benefits you’ll be sacrificing.
In a nutshell, there are three main types of workplace pension:
- Defined benefit (DB): This is a less common option these days but is basically when your pension is based on your pay at retirement and how long you’ve been part of the scheme. So your pension benefit is “defined” before you retire.
- Defined contribution (DC): By contrast, in a defined contribution plan your contributions are defined (because you pay a set amount each month, which you can change). You don’t actually know what your final pension will be – it’ll depend on how your investments have performed over time.
- Hybrid: This is when your pension plan incorporates elements of both DB and DC schemes.
It’s important to know exactly what the deal is with your workplace pension. Our article on how to get under the bonnet of your workplace pension will give you some useful tips on this topic.
If you decide to join your workplace pension plan, it’s generally seen as a good idea to do so as early as possible in order to get the maximum benefit of your membership.
What happens when I leave my job?
As millennials, we’re far more mobile in our careers these days than our parents and grandparents were. So as part of a “job-hopping generation”, it’s important we know how to deal with our pension if we change jobs. There are a few options:
- Leave your pension in your previous employer’s hands until you retire
- Transfer your pension to your new employer’s scheme
- Transfer your pension to a personal pension
There might be special rules relating to leaving or transferring your pension. The best option for you will depend on your personal circumstances, so it’s a good idea to get some professional advice so you can make an informed decision.
Personal pension plans
A personal pension plan is a type of defined contribution scheme but is a bit more flexible than a workplace pension because it’s not tied to a specific employer, but rather to a specific provider. The provider will offer you a set range of investments funds in which to invest your contributions.
One of the types of personal pension plans particularly worth mentioning is the self-invested pension plan or Sipp. As the name suggests, instead of handing over responsibility for the management of your pension to a pension provider, you take it on yourself (usually through a DIY investment platform). So you’re not restricted to what the pension provider offers; you can invest in a far greater range of investments (including directly into listed shares). It’s a big responsibility to take on though so the benefits of greater flexibility, portability and control should be weighed against your confidence in your ability to grow your money sufficiently.
What happens when I draw my pension?
While you don’t have to have stopped working to access your pension, most providers won’t allow you to access your pension until at least age 55. After that, you’re allowed to draw up to 25% as a tax-free lump sum. The remaining 75% is taxable and can be taken either as another lump sum, used to buy an annuity (which is a product that gives you a guaranteed income for life) or move your money into a drawdown fund (your money remains invested to provide you with regular but adjustable, taxable income).
You’re never too young to start saving
For many of us, retirement feels so far away it doesn’t seem like something to get too worked up about just yet. But as we’ve discussed before on MoneyLens, the earlier you start saving the better it can be (see this article on why your first 10 years of saving could be more powerful than the next 40 combined). Other than inheriting a fortune or winning the lottery (and let’s face it, the odds of either happening are not great for most of us), your pension is your best chance of living a comfortable retirement, so it’s a topic well worth educating yourself on.