What is a Pension?
A pension allows you to put money aside now while you’re working, to provide an income for when you retire.
Depending on the type of pension you have, you, your employer, and others such as your spouse or children can all pay into it.
The government also ‘contributes' to your pension in the form of tax relief; in other words, if you put some of your earned income into a pension, the tax they would normally have taken is ‘given’ back to you.
Pensions are free from income tax and Capital Gains Tax (CGT).
They are usually invested in stocks and shares, so as with any investment, the value can go down as well as up and you may get back less than you put in.
Depending on your personal situation, there are three types of pension in the UK:
Defined Contribution Pension Scheme:
You pay in a percentage of your salary and your employer also contributes to it as well; these pension contributions are then invested by a pension provider chosen by your employer. The income you get in retirement isn’t guaranteed and much depends on how much has been contributed and the performance of the investments within the pension.
Defined Benefit Pension Scheme:
Sometimes known as Final Salary Pension Schemes, you get a specified amount as pension income based on your salary and the number of years worked for your employer. You may have to pay pension contributions and your employer usually will as well.
‘Basic’ Personal Pension:
Making regular contributions to your personal, pension, these are usually managed by your pension provider or your financial adviser who can offer various investment strategies according to your personal circumstances and attitude to risk.
Similar to a ‘basic’ personal pension, there are strict government rules about how stakeholder pensions are managed such as low minimum contribution amounts, only a few investment options and maximum limits on provider charges.
Self-Invested Personal Pension (SIPP):
Usually more suitable for large pension contributions and experienced investors, a SIPP is a type of personal pension which comes with additional ‘bells and whistles’ and may incur higher charges.
The Basic State Pension could provide a useful supplementary pension income but should not be relied upon to support the type of retirement you’d probably like to have.
Your Pension at retirement
- Once you turn 55 years old or retire at a later date, you have a number of options as to how you take your pension income.
- The first 25% of your pension is tax-free with the remaining 75% taxed as earned income according to your rate of tax.
- Depending on the type of pension(s) you have, it may be used to mitigate against inheritance tax.
Things to think about...
- Don’t ignore your pension arrangements and leave them to chance.
- The earlier you start contributing to your pension, the better, as the potential for investment growth and the compounding effect may be maximised over the longer term.
- It’s important at an early age to calculate how much you need to contribute to your pension as this and future investment performance will determine your pension income in retirement.
- It’s a good idea to stay on top of your pension arrangements to ensure that your hard-earned money is working hard for you and being managed properly; for example, make sure that your pension investments are reviewed regularly.
- Consider pension consolidation as it’s more than likely that you will pick up more than one pension pot during a lifelong career (see ‘Pension Consolidation’).