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What is a pension and how does it work?

16–20 minutes to read

Pensions might sound very dull and boring, particularly if you are young. However, pensions are arguably one of the most important financial products you’ll ever have.

Getting your pension right will mean you have a happy, financially stress-free retirement. But get it wrong, and it could lead to hardship, stress and little room for enjoyment after decades of working.

While you might feel you have plenty of time for pension planning, time is one of the most important factors you have. Start young, however small, and it can have a dramatic difference in the outcome.

In this article, we’ll run through everything you need to know about pensions and how they work. Plus, we’ve got some neat tips and tricks to minimise the impact today whilst maximising future gains for tomorrow.

What is a pension?

Put simply, a pension is a long term savings plan. What makes a pension different from regular savings accounts, is that the government offers you incentives to save for your financial future.

The incentives a pension scheme can offer are usually in the form of tax breaks. Ultimately, this means more of your money goes into your pension.

One of the key differences is that you don’t pay income tax when you contribute money to a pension. Anything you would have previously lost to the taxman before putting money into a savings account can actually be clawed back with a pension.

Additionally, employers add to what you save into your pension. The current legal minimum ensures employees put in 5% of their salary and employers add at least 3% extra. This is a 60% gain and that’s just the minimum! Many employers match or even increase the percentage that employees pay in.

Pensions also use the benefit of time and power of compounding. They can’t be accessed until later in life which allows your money to grow. If you start young and continue contributing throughout your career, the results can be dramatic. We talk more about compounding in how to become a millionaire – the surprisingly easy way.

This makes pensions an extremely efficient vehicle to save for later life. But, as you may expect, there are some catches and restrictions which we highlight further down.

Heads up – We aim to produce honest and accurate content, however, we are not financial advisors. If you need financial advice, Unbiased can connect you with a suitable professional for free. Some of our links may earn us a small commission to help us run the site.

Most people have a pension

The government introduced the Automatic Enrollment scheme in 2012 which ensures all employees get access to a pension scheme. This covers the majority of workers.

The exception is if you are self-employed. In this case, you’ll need to sort your pension plans yourself. This is usually in the form of a Self-Invested Personal Pension or as it’s more commonly referred to a SIPP. You’ll still get to claim your tax back but there’s usually a bit more admin required.

Before Auto-Enrolment, employees would need to opt-in to a pension plan. Many employees saw this as a pay cut and so chose to have the cash now rather than the tax break and more money later.

Nowadays, employees have to opt out, which has seen a huge rise in pension adoption. While you still can opt out, most employees haven’t chosen this option.

If you are still opted out or are self-employed without a pension, then your likely missing out on some huge tax breaks. So, it’s worth reading on to see if you’d benefit from having a pension plan.

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What are the types of pension and how are they different?

The two most common types of workplace pension schemes are defined benefit and defined contribution. These two types of schemes work very differently.

For private-sector employees, defined contribution schemes are more common. You can check what type of scheme you have by speaking to your employer, checking your pension statement or calling your pension provider.

Some people have also opted to contribute to a Self-Invested Pension Plan (SIPP) which we’ll cover in more detail later.

Defined contribution pension scheme

In this scenario, employees pay into the scheme each month, usually as a deduction from their wages.

Defined contributions schemes aim to build a pension pot over the years building up to retirement. Funds in the pot are usually invested in the stock market which is managed by your pension provider.

Any gains your investments make are tax-free. Some schemes allow you to choose from a range of investments funds based on risk profile.

With a defined contribution scheme the responsibility for managing your money in retirement is with the individual. There is no guarantee of a fixed annual amount in retirement. Investments can go up or down so most seek financial advice when deciding how to draw down their pension funds in retirement.

Defined benefit pension scheme

Defined benefit pension schemes are nearly the opposite of defined contribution schemes. With a defined benefit scheme, the onus is on the employer.

Employers contribute to these schemes and it’s their responsibility to ensure there’s enough money in the pot to pay out for all employees. Employees can contribute as well.

Defined benefit schemes pay out a fixed amount each year in retirement. This typically increases over the years to keep pace with inflation.

You will often hear these schemes referred to as final salary pensions.

The amount you receive each year in retirement will be a calculation based on the length of time working for an employer and your last salary. It may also include other variables. This varies, so it’s best to contact your pension provider to get your projection.

Self Invested Pension Plan (SIPP)

A SIPP is a pension plan set up by an individual. SIPP‘s are often used by those who are self-employed, contractors or not in full-time employment. They can also be used to top up your workplace pension scheme.

The benefit of a SIPP is that the account holder has full control. You can usually invest in your chosen stocks, shares, funds or assets. Ultimately, a SIPP puts you in full control.

However, the drawback is exactly the same as the benefit. With this level of control, you also have full responsibility. You could invest in the wrong thing, you may not fully understand the risk you are taking and you could be paying higher fees.

SIPPs are also used when consolidating multiple smaller workplace pensions into one pot. If you are in this position, companies such as PensionBee might provide a happy middle ground for consolidating your old pensions while wrapping them in an easy to use interface.

If you want to take full control of your pension then here’s a list of the most popular UK SIPP providers:

If you are considering the SIPP route then make sure you read Investing for Beginners – How to bankroll your financial freedom. This will give you everything you need to get started.

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Tax relief on pensions

Pensions are one of the most tax-efficient savings wrappers that you can have. This is because the money you contribute doesn’t incur income tax.

When you earn money, the taxman likes to take their chunk. If you earn over £12,570 but under £50,270 (2021/22), then you pay basic income tax. This means every £100 you earn, you’ll lose £20 in tax. This reduces your take-home pay to £80.

Things get even worse for those earning above £50,271 (but under £150,000) as they will lose £40 out of every £100 earned. Meaning a take-home of only £60.

If you contribute this cash to a pension, you don’t have to pay the taxman his cut. So you get the full £100 in your pension and not the reduced amount.

By comparison, if you contributed this cash to a standard Cash ISA you would have had to pay income tax and so your pot would be smaller.

However, there is a catch. With pensions, you pay tax when you want to withdraw your cash. This referred to as being taxed on the ‘way out’. The idea is that you won’t need as high an income in retirement so you should end up paying less tax.

This is unlike ISAs where you don’t pay any tax on withdrawals, as you’d have already paid it on your contributions (taxed on the ‘way in’).

Think of it like this:

  • Pensions – no tax on the way in (contributions). You pay tax on the way out (withdrawals).
  • ISAs – you have already paid tax on the money you pay in (contributions). So you don’t pay tax on the way out (withdrawals).

How much can I put into a pension each year?

The maximum you can contribute to a pension each year is £40,000 (2021/22). This is called the annual allowance. The annual allowance is the total sum of all contributions combined, so you must include your employer’s payments as well as your own.

Furthermore, you cannot contribute more than you have earned. For example, if you earned £35,000 a year, the maximum you could contribute is £35,000 despite the limit being higher.

In fact, if you earn over £150,000 per year then the limit starts to lower. For every £2 you earn over £150,000 then your allowance will drop by £1. This continues to drop until your limit hits £4,000.

Under certain circumstances, you can also carry forward your unused allowance from the previous three years. This allows you to add up to £120,000 on top of your current years’ allowance.

Most of us won’t hit that £40,000 limit, however, there is another limit with pensions called the Lifetime Allowance.

What is the lifetime allowance on pensions?

While pensions can make an excellent savings vehicle for later life there is a limit to how much you can save.

This limit is called the Lifetime Allowance and it’s currently set to £1,073,100. It’s a generous allowance considering that the money you contribute receives no tax.

Remember though, whilst the limit might seem high, pensions are accrued over an entire lifetime. This limit can easily be hit, particularly for those with high incomes or who maximise their contributions. You can see how easily even small amounts increase over time by reading our How to become a millionaire article.

If you have multiple pension pots then it can be difficult to track your lifetime allowance. Having a defined benefits pension further adds to the challenge as the calculation to work out how much of the lifetime allowance you have consumed can be difficult. If you have multiple defined contributions pensions then there are services such as PensionBee that can consolidate these into one place to make your life easier.

Consolidating defined benefits schemes is much trickier and requires financial advice. Check out Unbiased for a list of professionals that can help you out.

If you go over your lifetime allowance then there are steep tax penalties of up to 55%. This is definitely something you want to try to avoid as it can negate all the great tax relief you’ve accrued over your career. As always, with something this important, it’s worth seeking professional financial advice.

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What about the State Pension?

The UK State Pension currently offers those who qualify an income of £179.60 per week. This works out as slightly over £9,000 per year.

You will usually need at least 10 qualifying years on your National Insurance record to receive any state pension. To get the full amount you’ll need 35 years.

The calculation is a little complicated but you can see what you’re entitled to on the government site by following this link – Check your State Pension forecast (see mine below).

If you qualify, your total pension income will be the sum of the State Pension plus anything you have in your private pensions.

State Pension Forcast

As you can see from my forecast above, I need to contribute to my National Insurance record for another 8 years to qualify for the full State Pension.

When can I access my pension?

We’ve split this into two sections as access differs for private and state pensions.

When calculating how much money you’ll need in retirement it’s important to understand when you can access both. This is so you are not caught short of funds while you are waiting to access your pension funds.

Read our guide on How much pension do I need to retire happily to help you plan your future finances.

When can I access the State Pension?

The State Pension can be accessed when you reach State Pension age. The problem is that the State Pension age is different depending on the year you were born. Currently, you can claim your State Pension at 66. It’s the same age for both men and women.

The age increases between 2026 and 2028 to 67 years old. And it’s set to increase again between 2037 and 2039 to age 68. This isn’t set in stone yet so we are waiting for the schedule to be confirmed by the government. You can check your age using the official government site here.

There is a good chance the government will keep increasing this age as the population increases in age. So if you are young and you don’t want to be working into your 70s then it’s a good idea to have a solid private pension plan.

The good news is that you can access your private pension funds sooner.

When can I access my private pension?

Private pensions can currently be accessed when you reach 55. However, like the State Pension, the age will increase to 57 in 2028. After this time, the minimum pension age will mirror the State Pension age but 10 years earlier.

Once you reach the minimum pension age, you can start planning how to withdraw your funds.

You can withdraw up to 25% of your pot tax-free. This can be in one lump sum or smaller instalments.

If you choose to take the 25% you can still continue to contribute to your pension. However, your annual allowance drops dramatically from £40,000 to £4,000. If you plan to keep working and contributing, this needs to be taken into account.

Taking a lump sum might help clear the mortgage, pay off debt or help your children or family out. The drawback to taking your cash out earlier is that it loses some of the most valuable years of growth where your money increases in value at the highest speed.

As always, with such a large decision it’s best to get support from a qualified financial planner.

Once you reach the minimum pension age you’ll need to decide how you plan to use your retirement pot. The next section covers the most common options.

Withdrawing your pension

In April 2015, the Pensions Schemes Act was brought into power. The act introduced new pension freedoms that allowed individuals more power and control around how they access their retirement funds.

Below, we cover the main options you now have for accessing your retirement funds.

1. Buy an annuity

An annuity guarantees you an income for life. Historically it was the most popular retirement option as it provides a fixed income until you no longer need it.

Annuities act like a salary, so there’s no need to change your financial habits built over a lifetime. They make budgeting much simpler and take away the financial stress of having to worry if your money will last.

2. Pension drawdown

With a pension drawdown, your money is usually left invested. You can choose what your pension pot is invested in or have someone do it for you.

Your income is not fixed, so you choose how much or how little to take out and when.

Unlike an annuity, a regular income is not guaranteed. You could end up drawing down all of your pension before your last days. This makes drawdown a complicated and potentially stressful option if you have little experience investing.

3. Withdraw the whole pot

Alternatively, you can withdraw your entire pension pot in one go. This option means you will be taxed after the first 25%.

Any pension payments taken after the initial 25% is treated in the same ways as if you earned them. This means you’ll pay income tax at the least.

Depending on the size of the pot, you could lose a good chunk of your cash to the taxman.

Once you have your cash, you’ll need to make sure it lasts.

For many, this is usually not the best plan as you are throwing away some of the great tax-saving benefits a pension wrapper can provide.

4. Use a combination

You don’t need to choose one plan over the other. You can use a combination of the options above.

For example, you could take the 25% tax-free option and then use some of your pot to buy an annuity. This could give you the additional peace of mind of receiving a fixed income. With whatever is left, you could choose to invest it and then withdraw some as and when you need it.

Whichever way you choose, careful tax planning can ensure you don’t get stung with a large tax bill. The next section covers some key considerations.

Tax considerations when withdrawing pensions

Essentially, your pension acts as a tax shelter for your funds. You don’t pay income tax on the funds you put into your pension or any capital gains tax if your investments increase in value. However, you will need to consider tax when you take money out.

Tax in retirement works in a very similar way to your working life. The tax you pay on your pension is based on your income. Your pension income is how much you take out of your pension pot each year plus any other income.

Also, you need to take into account any income you earn from other sources, how much you withdraw from your pension and your State Pension. All of these added together make up your total taxable income.

Here are the income tax bands in England, Wales and Northern Ireland for 2021/22:

Total Income Tax Rate
Personal allowance £12,570 0%
Basic Rate £12,571 – £50,270 20%
Higher Rate £50,270 – £150,000 40%
Additional Rate £150,000+ 45%

Example 1: A 70-year-old receiving the full state pension and an annuity of £18,000 per year.

The full state pension is around £9,000 and plus the annuity means this pensioner is earning a total of £27,000 per year.

The first £12,570 is tax-free which leaves the next £14,430 taxed at 20%. This means the pensioner is looking at a tax bill of £2,886. This reduces their total income to £24,114 for the year.

Example 2: A 55-year-old wants to withdraw their entire pension pot of £200,000 to pay off the remaining mortgage.

The first 25% is tax-free. The usual personal allowance is wiped out if someone earns over £125,140 so there is tax to pay on the remaining £150,000. Tax will be paid on everything else as below:

Basic rate: 20% of £50,270 = £10,054

Additional rate: 40% on £99,730 = £39,892

Total tax = £49,946!

As you can see, the person taking their pension all in one go loses 25% of their total pension pot in tax!

Careful planning and financial advice are usually required to ensure you don’t end up handing over your hard-earned cash back to the taxman.

What happens to your pension when you die?

When you pass away, any money you have left in cash savings, property or investments is subject to inheritance tax. The amount of inheritance tax you pay will depend on who you leave your money to and how much you have.

You can leave up to £325,000 tax-free, after this you’ll pay 40%. There are exceptions that allow you to go above this amount and your pension is one of them.

Pensions are seen as outside of your estate and as such do not count towards your inheritance tax threshold. That’s not to say you get off totally free from tax.

Usually, you won’t pay any tax on an inherited pension if you die before 75. After this point, things get a little trickier. As this is a complicated subject I would recommend you seek professional financial advice.

It’s also best to ensure you have a will in place. This protects your final wishes regarding what happens to your money when you are no longer here. You can write a will for around £100, plus check out our guide on how to use an online will writing service.

Conlusion

Pensions might seem boring at first but planned correctly, and a decent pension can make for a very happy retirement. I don’t know about you, but I certainly don’t want to be worried about money when I’m retired.

Making the most of your pension allowance and getting the maximum employer match can instantly double your money. For higher taxpayers, the effects are even more dramatic.

The key is starting your pension as young as possible and making the most of that juicy compounding effect. Even if you started late, then starting now still gives you some of those great tax breaks.

If you still have questions then come join our supportive Facebook UK Personal Finance club where you will find other like-minded individuals. It’s a safe community where you can ask questions and learn more about making the most of your money. Best of all, it’s free! I’d love to see you there.

Here’s to Financial Fitness

EatSleepMoney.co.uk does not offer financial advice and is intended for reference/information only. Remember, you should always carry out your own research and/or take specific professional advice before choosing any financial products or services or undertaking any business or financial venture. If you need financial advice Unbiased can connect you with a suitable professional for free. Investments may go up as well as down and you may get back less than you put in.