The Government recently carried out a consultation on the structure of pensions based on a number of issues, one being the complexity of pensions….. But what is a pension? And are they really complex?
A pension is simply a long term savings vehicle for later in life. Traditionally, pensions were designed to generate income, replacing salary and therefore payments out coincided with ceasing work. Now money can be withdrawn from a pension at any time over the age of 55 (increasing to 57 from 2028) and money can be taken as income or lump sum(s).
Types of pension
There are broadly 3 different types of pensions:
- the State Pension (provided by the State based on National Insurance Contributions)
- Defined Benefit Pensions (where an employer promises a pension income based on salary and length of service)
- Defined Contribution Pensions (where what you/your employer pay into the pension determines what you get out)
Here I will focus on the latter.
Pensions are simple
A pension is just like any other form of investment with certain tax advantages.
All investments whether it be an ISA (Individual Savings Account), a pension, a bond or a general investment account all work in much the same way apart from their tax status. This is why they are often called “tax wrappers”.
Whatever tax wrapper you put your money into, it will be “invested” in much the same places whether it be cash, government or company loans, and commercial property or company shares. Your money will be “pooled” with other investors’ into funds that hold a mixture of these “assets” based on your attitude to risk, term of investment and a number of other factors.
In essence, you could hold the same funds within your ISA as in your pension.
Back to pensions….. What does the pension tax wrapper mean for your investment?
1) Whatever you pay in will earn tax relief
What does this mean?
The government will (currently) pay into your pension based upon the amount you pay in and your income tax rate (Basic, Higher or additional). So based on the amount you pay in, you will receive tax relief at 20%, 40% or 45% essentially refunding you with the tax you have paid.
Bob is a 20% taxpayer, he makes a regular contribution into his pension of £80 per month. Every month, he receives tax relief of £20. It therefore costs Bob £80 for £100 to be invested into his pension each month.
Audrey is a higher rate taxpayer, like Bob, she receives £20 tax relief from the government into her pension. To claim the additional £20 she completes the relevant section on her tax return and receives either relief as a rebate at the end of the tax year, a reduction in her tax liability or an alteration to her tax code. Thus the £100 contribution cost her £60.
The maximum a tax-payer can contribute and receive tax relief is either the equivalent of 100% of their relevant UK taxable earnings or £40,000 (2017/18) whichever is lower. However, if you earn over £110,000, the amount you can pay in may be less than £40,000. For anyone earning over £150,000, their allowance will be tapered down and those earning over £210,000 will be limited to contributions of £10,000 per annum. In some instances, the amount will be limited to £4,000.*
Non tax-payers can still receive tax relief up to a maximum of £3,600 or 100% of earning whichever is greater. If you have relevant income below £3,600 the maximum you can pay is £2,880 and you will receive £720 tax relief making a total (gross) contribution of £3,600.
Within some employer pension schemes, pension contributions will be taken from gross pay (before tax is deducted) therefore will not receive further tax relief.
2) The investments grow free from tax
What does this mean?
Any growth within a pension fund is not taxed
3) When you take your money out, 25% is tax free and the rest is taxed at your marginal rate
What does this mean?
You can take money out of your pension from age 55. When you come to take money out of your pension, 25% of the fund is free from tax (sometimes referred to as tax free cash or pension commencement lump sum) with the rest taxed as income. In reality, the 25% doesn’t need to be taken as a lump sum and the rest doesn’t need to be taken as income. The manner in which the money can be taken is very flexible and will depend on the individual, their circumstances, tax position and pension provider.
4) What happens to your pension when you die?
Pensions can be passed to a nominated beneficiary usually free from inheritance tax. The pension can be paid out as a lump sum, an annuity or could be taken as a beneficiary’s pension. If you die before age 75 there will be no tax to pay. If you die after age 75, the pension will be taxed at the beneficiary’s income tax rate. Not all pension plans offer all of the death benefit options. To find out more, you can read my blog What Happens to my Pension if I Die?
So, what is a pension?
A pension is a tax wrapper that has some advantages – tax relief on contributions and tax free growth. Pensions also have some restrictions – money cannot be taken out until age 55 and only 25% is tax free with the balance being taxed as income – unsurprising really when they were designed as long term savings vehicles to provide income upon ceasing work.
The information contained within this document is correct as at 2018/19 tax year and is based on current government legislation. This can (and probably will) change.
* The amount you can pay into a pension will be limited to £4,000 when you have triggered the Money Purchase Annual Allowance. This is triggered when you take Income from Flexi-access Drawdown or take an uncrystallised pension lump sum (UFPLS).