What is a pension, and why should everyone have one?
Essentially a pension is simply a pot of money that you save into for retirement. The state pension is currently £241.30 per week, and that assumes you have a full national insurance record; according to the annual Retirement Living Standards survey, an individual needs £32,700 a year after tax to enjoy a ‘moderate’ retirement, and this assumes no housing costs – so saving into a pension is a vital part of covering that shortfall.
What are the tax benefits of a pension?
A contribution into a pension can attract tax relief which can help to boost the value of that contribution. For example, by paying in £100 of your own money into a pension, you will receive £25 in tax relief, boosting your total contribution to £125, the equivalent of a 25% return on your funds before they have had the chance to grow further within your pension. For higher rate taxpayers, you can claim even more tax relief.
If you choose to pay into your pension via your salary, your contributions can be taken before your salary is taxed, so your overall income tax bill is lower. What’s more, the growth of your pension fund is not taxed (unlike many savings accounts and other investments), so a pension remains one of the most tax efficient ways of saving for your retirement.
The maximum you can pay into a pension each tax year, inclusive of tax relief, is the lower of £60,000, the level of your annual gross earned income, or £3,600.
You can contribute into a pension for yourself or on behalf of others, such as for children or grandchildren.
Isn’t it better to invest in property?
I speak to many people who want to invest some cash and ask whether property might be a better home for their money. Of course, every case is different so it’s not possible to give a definitive general answer, but property investment has been a target of recent government tax and regulatory changes, making it less attractive to investors, whereas the tax relief on pensions has remained unchanged.
It is, of course, possible to channel pension savings into property-based investments, if that is what you want to do. You can use your pension funds to invest into commercial property through your pension too. For example, if you are a business owner, you could use your pension funds to purchase a property for your business to use, such as a main office or a storage unit.
What are the main types of pension?
At one time the most common pension type was a defined benefit pension, most commonly a workplace scheme, which paid a pension based on either your final or your career average salary. This type of pension has largely disappeared in the private sector, but is still commonplace for public sector workers. With this type of pension, the employer is taking all of the risk – the eventual pension which is paid to retirees is guaranteed.
Much more common nowadays is the defined contribution workplace pension, where (usually) an employer and an employee each contribute a set percentage of the employee’s salary into a pot, with the eventual retirement income dependent on the investment performance of the pension.
A personal pension is similar to a defined contribution pension, but it is not linked to a particular employer or workplace (although an employer can still pay into it). It is up to the individual how the money in the pension is invested – perhaps in a series of managed investment funds, or even in cash – and that decision will depend on the individual’s attitude to risk and what their financial objectives for retirement are.
What is a Self-Invested Personal Pension (SIPP)
A SIPP is simply a pension where the individual has total control over how the money is invested, and this can be other avenues than managed funds and cash. So someone who didn’t want to expose themselves to the volatility of stocks and shares could in theory invest their SIPP in ordinary bank accounts.
Alternatively (and more commonly), those with SIPPs may go down alternative investment routes: residential or commercial property, for example. This could be a property which you buy through the pension and lease back to your own business, taking advantage of the fact that that rent is tax deductible through the business, but not taxable within the SIPP.
How does market volatility affect pensions?
We live in a turbulent world, with political and economic shocks affecting market performance and investment returns. What is important to realise is that a pension is a long-term investment, and over time much of that market volatility will smooth itself out. As the individual gets closer to their retirement date, there may be a need to de-risk the pension investments to an extent, as there will be less time to recover from a short-term market shock before they need to start drawing on the pension.
One crucial point is the importance of regular reviews of pension performance, to ensure that the investment choices are still optimum, and that the pension is on track to meet the individual’s retirement objectives.
How can business owners use pensions to minimise the tax they pay?
Business owners who have the option of their company or business paying pension contributions. With many small businesses paying a marginal taper rate of 26.5% corporation tax, diverting those profits into pension contributions instantly reduces their corporation tax bill by 26.5% of the contribution, making this a tax efficient way of extracting money from a business rather than salary or dividends.
What happens when you want to access your pension?
The first thing to know is that you can currently take 25% of your pension tax-free, up to a maximum of £268,275, from the age of 55 (this rises to 57 in April 2028). You don’t have to take it all at once; you can take it in chunks throughout your lifetime. Further income drawn from your pension is taxed like any other income, at 20%, 40% and 45% depending on your income
The second consideration is that you need to plan how you will take your pension income, both so that you have enough to live on and also so that your pension pot won’t run out. Modelling how much you will need during each stage of your retirement is very important (typically people spend more in the earlier years of their retirement, as that is when they are more likely to travel, for example – but everyone is different).
What are the options for taking retirement income?
There are essentially two main options when it comes to taking your income in retirement.
The first is to buy an annuity, which will pay a guaranteed income for the rest of your life. This can be a level annuity – i.e. one which does not increase year-on-year – or a rising annuity, which will increase by a set percentage annually to help combat inflation. Annuities can include provision for partners after your death. The advantage of this route is that you have a guaranteed income; the disadvantage is that your pension dies with you, and there is nothing to leave to your family.
The alternative is to leave your pension pot invested and draw down income as your need it. In this scenario the invested funds continue to grow, and if you die, the whole pot passes to your beneficiaries. The downside is that you need to plan carefully that the money doesn’t run out; in addition, there is a slightly elevated risk that you will be vulnerable to market volatility.
You can opt to use some of your pension pot to buy an annuity (say to cover your basic living costs) and leave the rest invested for future drawdown.
What happens when you die?
Currently, if you die before the age of 75, your pension funds pass tax-free to your beneficiaries; if you die after your 75th birthday, they will pay tax on that money at their marginal income tax rate.
From April 2027, pensions will move from being exempt from inheritance tax to forming part of an individuals estate for inheritance tax calculation purposes. This means that a tax charge of 40% could be applied to some or all of a pension fund, depending on the value of your taxable estate, and in addition to this, your beneficiaries may also have to pay income tax on receiving the pension too.