What is a pension?
A pension is a tax-free pot of cash that can be paid into by you, your employer, and sometimes the government. It is the most common way of saving for retirement.
The money that is saved can be invested. Returns allow the value of your pension pot to increase over time.
When you retire, the money in your pension pot is used to provide you with an income, without having to work.
However, saving into a pension means you will be giving up some of your disposable income in the short term.
Are pensions worth it?
Saving into a pension has several benefits:
- You receive tax relief on contributions. This means that money which would have originally gone to the government in the form of tax goes into your pension pot instead. It is essentially free money from the government.
- Investments in your pension pot experience compound growth. This means that any returns are reinvested, and are therefore used to generate more money. The earlier you start saving, the more you will benefit from compound growth and the greater your income will be during retirement.
- If you are employed, your employer must make contributions to your pension pot too. This is like getting a pay rise which you will receive when you retire.
- Saving into a pension will provide you with a much higher income during retirement compared to just a state pension. The state pension pays very little and therefore cannot be relied on as your main source of income when you retire.
How does tax relief work?
Tax relief is where any income tax paid on pension contributions is given back to you by the government and added to your pension pot.
The amount of tax relief you receive depends on which income tax bracket you are in. Everyone receives 20% tax relief automatically, however higher and additional rate income taxpayers are entitled to 40% and 45% respectively.
It is important to note that to receive the extra tax relief on the higher and additional rates of income tax, it must be reclaimed. If you do not reclaim the money, it will not be paid.
Some employers deduct pension contributions before taxes from your pay packet. In this case there is no need to reclaim additional tax relief as your employer would have just deducted less tax. However, do not assume that your employer does this. It is always best to check with them first to avoid missing out on any tax relief.
Tax relief of 20% does not mean you get back 20% of what you paid in for example. The taxman works out how much you would have had to earn to put that money in and gives back the difference between your contributions and pre-tax earnings.
The table below illustrates how tax relief works, to pay £100 into a pension.
|Basic Rate||Higher Rate||Additional Rate|
There are no limits to how much you can contribute into a pension, however there are limits to how much tax relief you can receive:
- An earnings limit – you can only receive tax relief on contributions up to the value of your total annual earnings. If for example you had £40,000 in savings that you wanted to put into your pension pot, but an annual salary of £25,000, you could only receive tax relief on contributions up to £25,000. Therefore, to maximise tax relief it would be better to transfer your savings into a pension over a few years, rather than all at once.
- An annual limit – There is an annual limit to the amount you can contribute to your pension and receive tax relief, even if your earnings are higher. The annual limit is currently £40,000.
- A lifetime limit – For the current 2018/19 tax year the lifetime limit is £1,030,000. Once you have reached this limit you will receive no tax relief on further contributions.
How much should I save into my pension?
Pension schemes under automatic enrolment require a minimum contribution, however this is not enough to be sufficiently prepared for retirement.
How much you need to save depends on your age, as well as how you want to live during retirement.
A general rule of thumb is that the age you start saving into a pension, half it, and save that percentage of your pre-tax income each year until you retire.
This means that if you start at the age of 24, you should save approximately 12% of your pre-tax income every year.
Whilst this may seem like a lot, do not forget that it includes your employer contributions as well as tax relief from the government.
The key is to start saving as early as possible, preferably as soon as you get your first job after leaving education. That way you get used to saving a certain percentage of your income each year. If for example you have spent 100% of your income every year for ten years, it will be much more difficult to adjust to having less disposable income when you start saving into a pension.
Another tactic is to increase pension contributions as your salary rises. If for example you get a pay rise of 4%, you may want to increase contributions by 2%. That way you will be saving more, as well as still having more money to spend.
Are pensions risky?
A pension is just the term given to the pot that your money is saved in. Pensions themselves aren’t risky.
Where the risk comes in is with the investments, using money from your pension pot. As with all investments there is a chance that the value may fall and you lose money.
There are however a number of tricks you can use to reduce overall risk, such as diversification.
If you wanted to remove almost all risk, your pension could consist of just cash rather than the money being invested in assets. This is however much less lucrative and the value of your savings becomes vulnerable to inflation, especially considering interest rates are currently very low.
Another thing to consider is that the benefits of saving into a pension, such as the tax relief and employer contributions, will likely outweigh the risks from investment.
What you don’t want to do is avoid saving into a pension and then find yourself unprepared for retirement.
Alternatives to using a pension
A pension is not the only way of saving for retirement. Other methods include:
- ISAs – This is a tax wrapper which allows you to invest money in a range of assets. Whilst there is no tax relief when you pay into an ISA, income is tax free and there is no capital gains tax on investment profits. In addition, you can access your money when and how you want.
- Reverse Mortgage – If you own your home, you can use a Reverse Mortgage to provide an income during retirement. The Reverse Mortgage provider pays you a monthly sum of money in return for ownership of the house when you die.
- Downsizing Your Home – If the value of your home is greater than the outstanding mortgage, you can sell your home and downsize, to release some of its equity.
- Property – Renting out a second home can provide a good income during retirement, however it is less flexible than most options. If you sell the home, you will have to pay capital gains tax.