What Is a Pension and How Can I Make It Work For Me?

There’s no denying that everyone wants to lead a comfortable life once they reach retirement age. While some people regularly put some money into a savings pot from their twenties or middle ages, others prefer to grow their money with a pension.

In a nutshell, a pension is a tax-efficient way of saving money for your retirement. It provides you with an income when you retire and are no longer working for a living. Learn more about pensions with this handy guide and how you can make a pension work well for you.

Pension Consolidation

Why Should I Have a Pension?

When you retire or turn 55 years old and decide to work significantly less than you do today, you’ll still need an income. If you start thinking about a pension sooner rather than later, you’ll be more prepared for your financial future.

Plus, the earlier you start planning your pension, the higher the chance you’ll have of leading the retirement lifestyle you’ve always wanted. While there are many ways to save and invest, a pension provides many benefits.

For example, you’ll get a tax relief of at least 20% on any contributions made to your pension ‘pot’ (up to a specific limit). Plus, if you’re a higher or additional rate taxpayer, you can claim even more tax relief via your tax return.

If you’re an employee, the business or organisation you work for has a legal obligation to contribute to your pension. Finally, the money invested into your retirement pension is free of income tax (as long as you pay no more than £40,000 per tax year)  and capital gains tax.

The only tax you may need to pay is income tax on any money you withdraw from your pension.

Which Retirement Pensions Are Available?

There are three different sources where you can receive a pension income when you retire. They are from the state, former and existing employers, and personal pensions that you set up yourself:

State Pension

In the UK, the government offers all eligible citizens a state pension when they reach a certain age (currently 66 years of age for men and women).

The government is increasing the state pension age to 67 between 2026 and 2028 and again to 68 between 2037 and 2039. They claim that increasing state pension ages is because people are generally living longer, and they want to make the system fair for all.

If you’re unsure when you’re able to get the state pension, you can check your state pension age on the government’s website by entering your birth date on a form there.

The eligibility criteria for the state pension, at the time of writing, is as follows:

  • You have reached the state pension age;
  • You must have at least ten ‘qualifying’ years on your National Insurance (NI) record. They don’t have to be ten years in a row. A qualifying year is where:
    • You worked and paid NI contributions
    • You received NI credits;
    • You paid voluntary NI contributions.

At present, the maximum basic state pension you can receive is £179.60 per week. Of course, the amount you receive will depend on the NI contributions you’ve made, as you could receive less than £179.60 per week if you’ve got a shortfall.

Workplace Pension

The law currently states that all employers must contribute towards a pension for their employees. Both you and your employer will pay into your pension plan, and the government boosts those contributions through tax relief (more on that later).

An exception to the law on workplace pensions is if the employee voluntarily opts out of their workplace pension. Of course, employers cannot pressure you into doing opting out of that.

There are two different types of workplace pensions: defined contributions and defined benefits.

What’s a Defined Contribution Pension?

A defined contribution pension is where you and your employer pay money into a pension fund. Those contributions made into the pension fund get invested into a portfolio of assets that can comprise equities like company stocks and shares, bonds, and property.

As you can imagine, there’s an element of risk involved with investments. But, the good news is you can select the level of risk you’re comfortable with. Generally speaking, high-risk investments can yield more significant increases, but they can also result in losses.

A young individual that still has a few decades to go before retirement might select a high-risk or medium-risk defined contribution pension. In contrast, someone closer to retirement age may opt for a low-risk alternative.

The idea behind a defined contribution pension is that your contributions will theoretically grow and result in a higher pension income when you retire.

What’s a Defined Benefit Pension?

Another option for employees (predominately public sector workers) that want a workplace pension is to have a defined benefit pension. It’s where your employer’s pension scheme agrees to pay you a fixed income from a specific agreed date.

The income you receive will depend on a few factors, such as:

  • Your salary when you finish working for your employer, or the average salary earned with them;
  • The number of years you’ve worked there while being a member of their pension service;
  • The accrual rate (the rate that your pension income builds up).

The accrual rate is usually 1/60th or 1/80th of your final salary for every year you were part of the pension scheme. To calculate your pension income if you have a defined benefit pension, you would work it out as follows:

  1. Multiply the number of years you’ve been a part of the pension scheme (your pensionable service) by your final salary;
  2. Divide that total by your accrual rate.

For example, say that you’ve been with your employer’s defined benefit pension scheme for ten years, you were on a salary of £24,000 per year when you retired, and your pension scheme’s accrual rate is 1/60th of your annual salary.

  • 10 x 24000 / 60 = 4000.

That means you will receive £4,000 per year, although the figure could be less if you withdraw a tax-free cash lump sum.

As mentioned earlier, a defined benefit pension is usually offered to public sector workers – although some private sector companies do offer them. It’s possible to transfer a defined benefit pension to a defined contribution one before reaching retirement age.

Personal Pension

The final option, a personal pension, is one that you arrange yourself. Self-employed people typically organise personal pensions as they don’t have an employer to arrange their pensions on their behalf.

There are three types of personal pension:

  • Simple personal pension – one that gets managed by a pension provider and where you make regular contributions;
  • Stakeholder pension – a restricted version of the simple personal pension with strict limits set by the government and caps on contributions and investment options;
  • SIPP (self-invested personal pension) – a pension where you have complete control over your contributions and investments.

All personal pensions are defined contribution types, and they are similar to workplace ones but with some subtle differences:

  • Only you contribute to the pension as you don’t have an employer;
  • You don’t always have to make regular contributions.

As with workplace defined contribution pensions, you will receive tax relief from the government on your contributions.

Is a Pension Income Taxable?

From a tax perspective, the government treats withdrawals from pension plans as income, and so they are taxable. However, the good news is the government allows you to withdraw a total of 25% of your pension pot tax-free.

What’s more, that tax-free amount doesn’t use any of your personal allowance – currently £12,570. The remaining 75% of your pension cannot remain untouched. You must withdraw it in one go or in chunks.

If you choose to withdraw the balance in one go, you can purchase an annuity (guaranteed income), have an adjustable income (flexi-access drawdown) or withdraw the entire balance at once. If you decide to withdraw the balance in chunks, 25% of each ‘chunk’ is tax-free.

What Is the Tax Relief on Pensions?

A significant advantage pensions have over ordinary investment is tax relief. With any contributions you make into your pension pot, the government will refund you the tax you paid on that portion of your income.

Basic-rate taxpayers get 20% tax relief which will essentially boost pension contributions by 25p for every £1.00. If you get taxed at a higher rate, you will get 40% tax relief or around 66p for every £1.00.

Most basic-rate taxpayers will receive their tax relief automatically, but higher-rate taxpayers must claim the extra relief through their tax returns.

How Do I Arrange a Pension?

If you’re an employee, the business or organisation you work for will automatically enrol you into a pension scheme. If you’re self-employed, you can set one up yourself.

Everyone is free to have more than one pension. For example, you could have a workplace pension and arrange a personal pension to diversify your investment risk. You could find that combining your pension pots at retirement will mean you are financially better off.

Final Thoughts

Pension planning is highly beneficial for your financial future when you retire. Pensions are tax-efficient savings and investment vehicles, and the earlier you arrange a pension, the better return you’ll potentially receive when you retire.

Looking for expert financial advice? Get in touch to speak to an adviser

Risk Warning
Any investment carries a degree of risk and your investments may decrease in value or fail. The levels and bases of taxation and reliefs can change at any time and are dependent on individual circumstances.