You may have heard a lot about pensions in recent years, but you might not be fully up to speed with the benefits and why this is one of the best places to keep your money. Find out why it’s worth considering paying more into your pension.
Are pensions worth it?
If you’re anything like me, you probably thought that the State Pension and a little bit of savings would see you through retirement quite comfortably. But sadly, that’s just not true.
Even if you qualify for the full pension, that’s still under £200 per week. And at today’s prices, that will be quickly swallowed up by heating and food costs.
So, it’s important that you have some extra income when you hit retirement, whatever age that might be. And one of the best ways to do this is to have your own pension.
How does a pension work?
At first glance, pensions are quite confusing as there are various types. That’s probably why many of us just ignore them. But dig a little deeper and they aren’t too difficult to get your head around. Eventually…
Apart from the State Pension, there are two other types of pension you could possibly pay into:
- Personal pension
- Workplace pension
You’ll usually pay monthly into your pension, which is then invested on your behalf and should see your money grow. When you reach retirement age, your pension pot will be worth a set amount, which will then give you a lump sum and a monthly income until you pass away.
Depending on the scheme you join, you can start claiming your pension at a set age, usually 60, 65 or 68. In some cases, you can take it as early as 55 (this will increase to 57 from 2028). But it’s important to note that the earlier you draw your pension, the less your monthly income will be.
What are the main benefits of a pension?
There are several benefits when it comes to having a pension.
Tax-efficient – as we all know, you get taxed on almost everything. If you’re a basic rate taxpayer, for every £1 you earn, you’ll receive under 70 pence before it reaches your pocket. For a higher rate payer, this is even less. But pay this £1 into a pension and it won’t be taxed.
A boost from your workplace – if you’re an employee, your employer will also make a contribution to your pension when you make a payment. This is a great way to get extra money from your company.
A tax-free lump sum – when you decide to withdraw your pension, you can usually take up to a quarter of your pension pot as a tax-free lump sum.
A steady income when you retire – as I mentioned above, a pension will mean an extra monthly income in retirement. This can be combined with a State Pension and any other savings you may have.
How do you start your pension?
If a pension sounds tempting to you, how do you get started?
The government introduced ‘auto enrolment’ back in 2012, meaning that employers legally had to set up a workplace pension for all of their qualifying employees. If you’re over 22, earn more than £10,000 per year and are not already in a scheme, you’ll be enrolled.
If you earn less than £10,000 but over £6,240, you can ask to be added to your workplace pension and your employer must accept.
There are two types of workplace pension available
- Defined contribution (also called ‘money purchase’)
- Defined benefit (also called ‘final salary’ or sometimes ‘average salary’)
The defined benefit scheme does tend to be the most generous pension. You agree to pay a certain amount and you’ll receive a set sum at retirement. It doesn’t matter how your pension fund performs.
On the other hand, a defined contribution scheme means that you contribute a certain amount each month, but you can’t be sure how your investment will perform. That means that potentially, your pension pot might not be worth as much as you hoped when you come to retire.
Because of this, most employers no longer offer the defined benefit scheme. However, it’s still common in the public sector (read more about the Alpha pension)
In general, the minimum you can contribute to your pension is 5% (which includes tax relief) and your employer will add 3%. However, some employers are more generous and will add more than the minimum.
Your tax relief is automatically calculated when you receive your wages.
If you want, you can opt out of your pension scheme, but this does mean losing your employer’s contributions.
If you’re self-employed or you don’t have a workplace pension for another reason, then you can set up a personal pension. The two main types are
- Stakeholder pension
- Self-invested personal pension (SIPP)
SIPPs are generally the most common and allow you to control the specific investments that make up your pension fund. Take a look at companies like Fidelity and Nutmeg to find out more about opening a SIPP.
You can pay lump sums into your personal pension or contribute monthly. However, different providers have slightly different terms.
To claim your tax relief from your pension, you will need to declare your payments when you complete your tax returns.
Why is the pension scheme so generous?
You’re probably asking yourself why the government is being so generous and giving us these huge tax breaks? Well, as we get older, we become more of a burden on the country. If we have a bigger income in our retirement age, we won’t have to rely on the state to help us out as much.
Plus, if your monthly income in retirement is large enough, the government will still get to tax it. That means the country gets to tax you for far longer.
And that’s probably what it’s all about.
So, are pensions worth it?
This really is a great way to save for your future. Not only does it reduce the amount of tax you’re liable for, if you’re employed, it means an increase in pay too.
Personally, I don’t put every spare penny I have into my pension though as I don’t like the idea of not being able to access it until I reach a certain age. But it certainly makes up the bulk of my retirement plans.
If you’re looking for other ways to save towards retirement, take a look at my review of the Lifetime ISA, which pays a 25% bonus.
Is it worth paying into a pension for 5 years?
If you can afford to, it’s worth paying into a pension whenever you can. So if it’s 1 year or 40, it should still give you a financial benefit.