As accountants, we deal with the increasingly complicated world of pensions every day. But although it's all (fairly) clear to us, it's actually an area that's obtuse and intimidating to many people. So here's a primer on the basics of how personal pensions work!
A personal pension is just a tax-advantaged method of saving for retirement. The good thing is that the government will add something to the pot in addition to whatever you save, and the contents of the pot can grow tax-free. The bad thing is that the price you pay is being unable to get your hands on any of the money until you're at least 55 years old.
How much can I save into my pot?
Fundamentally, the maximum contribution (the Annual Allowance) in a year is £40,000. It's more complicated than that, though. That £40,000 allowance starts to get reduced if you have income greater than £150,000, and if you have income greater than £210,000 your Annual Allowance is only £10,000. But you can generally carry forward unused Annual Allowance for up to three years, so in certain circumstances someone might be able to contribute £160,000 in one go!
Although getting 20% tax relief on contributions generally relies on having enough income that you've actually paid a matching amount of tax, anyone can contribute £3,600 in a tax year, even if they're paying no tax at all.
So, how does this tax relief work?
For every £80 you put in, the pension company asks the government for a further £20. So that means you've £100 in your account, and you're out of pocket by only £80. That's basic rate tax relief (i.e. you've saved 20%).
Should I put the contributions on my tax return?
If your income is below £50,000, nothing happens, so including the contributions won't make any difference to your tax bill. Your income has topped out in the basic rate tax band where tax is charged at 20%, and you've had all the tax relief you're due.
But if your income is above £50,000, you'll save some more tax. If someone who has contributed that £80 to their pension is in the higher-rate band, the government will knock another £20 off their tax bill. So now they've got £100 in their account and are only £60 out of pocket. That's higher-rate tax relief (i.e. you've saved 40%).
You can save even more if your income is in a higher tax bracket.
What about if I work via my own limited company?
In that case, it's generally marginally better for the company to make contributions directly to the pension company as your employer, rather than you making them personally. The company puts the whole amount into the pension, and its corporation tax bill is reduced as a result. It's vital that the pension company knows they're receiving an employer contribution rather than a personal one, though.
Where do I get a pension?
There are lots of providers. Because we're not Independent Financial Advisers (IFAs), we're not allowed to tell you exactly where to put your money, though we've some more content we can share about the options and what we see people doing. For personal advice, we've a handful of IFAs who trust and are happy to recommend.
What happens to my money whilst it's in my pension?
It'll generally be invested in something - funds, shares, bonds, that kind of thing.
In the simplest, cheapest products that may simply be done for you, based on your age and anticipated retirement date. Broadly, the younger you are, the riskier the investments will be - since you've a long time horizon, more volatile investments with a greater anticipated long-term return are likely to be more appropriate than something more steady and boring. As you approach retirement, they'll be gradually switched into less volatile investments - it's a process known as lifestyling.
At the other end of the spectrum, some people like to actually pick and choose their own investments within the pension, or have an adviser do it for them. And there are points in between where you can make high-level choices but leave the detail to someone else, or to a robot.
How do I get money out of my pension?
It'll depend on the rules when the time comes. They're quite different now to the way they were 10 or 20 years ago, and you can expect them to be different in the future too. The general shape of things at present for most people is that you can get 25% of the pot tax-free, then as you draw out the remainder you'll pay tax on it as part of your income as you take it. If someone can save 40% tax when they contribute, grow their pot tax-free, and then get a quarter of it out without paying any tax and potentially pay tax at no more than 20% on the rest, that could be pretty attractive.
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