Guide to UK Pensions

A pension is a long-term savings plan that you will use in later life to fund your retirement. Pensions are amongst the most tax-efficient ways to save for retirement. Not only do they cut your tax bill, they also grow almost tax-free.

The Benefits of Saving for a Pension

The benefits of saving for a pension are:

• It’s one of the most tax-efficient ways of investing. When you contribute to your pension, your pension provider adds another 20% to your pension pot. It claims 20% tax relief on your contribution from the government. If you are a higher earner it could be more.
• Your pension fund grows largely tax-free. (This depends on the pension scheme investment activity.)
• Contributing to your pension cuts the tax you pay to HMRC, whether you are an employee or work via a limited company.
• You can access your private retirement account at age 55 (which will increase to age 57 from 6 April 2028). This is currently 11 years before you can access the UK state pension.

How Much Can You Contribute Annually?

The annual limit for 2023/2024 is £60,000. You can pay up to £60,000 or 100% of your earnings in the UK (whichever amount is lower) into your pension annually and get tax relief. Additionally, you can carry forward unused allowances from the previous 3 years.

The Lifetime Allowance

Previously, if you had £1,073,100 in your pension pot you had to pay a tax charge on the excess amount at the time of withdrawal from the pension. This charge has been abolished and from the 2024/2025 tax year, the lifetime allowance will be removed so you can save as much as you want in your pension.

Types of Pensions

There are personal and workplace pensions.

Personal Pensions

Standard personal pensions: Most large pension providers offer these with a range of investment choices.

Stakeholder pensions: These must meet minimum requirements as set by the UK government such as:

• minimum contributions of £20.

• a cap on charges, 1.5% of the value of your pension in the first year, then 1% after that.

• you can stop or re-start contributions at any time.

• charge free transfers.

• your money will be invested in a default investment fund if you do not want to choose a fund.

Self-invested personal pensions (SIPP): You choose the fund provider and what you invest in. You should have a large choice of investments to choose from e.g., index funds, ETFs, shares, bonds etc. Note that fees may be higher.

Junior SIPP: You can set up a Junior SIPP for your child. You can contribute up to £3,600 for the 2023/2024 UK tax year. Your child gains control of the SIPP when they turn 18. However, they cannot get access to it until they turn 57 (from 2028).

Workplace Pensions

Your employer sets up your workplace pension for you. A percentage of your salary is automatically deducted each month and put into the pension. Your employer contributes a fixed percentage.

The legal minimum that must be paid into your pension each year is 8% of qualifying earnings. Qualifying earnings is any pre-tax employment income between £6,240 and £50,270 for the tax year 2023/24. Your employer must pay a minimum of 3% with the remaining amount paid by the employee out of pre-tax employment income. You also get tax relief on your pension contributions.

Auto-enrolment into a workplace pension

“Automatic enrolment is one of the key employer duties. The core requirement is that employers must make arrangements so that their eligible jobholders become active members of an automatic enrolment pension scheme from their automatic enrolment date” Source: The Pensions Regulator

To qualify for auto-enrolment into a workplace pension you must

• Work in the UK.

• Be aged between 22 and the UK state pension age.

• Earn more than £10k per year from one job.

• Not be self-employed or a sole director of a company with no other staff.

• Not already in a suitable workplace pension scheme.

Types of Workplace Pensions

There are three types of workplace pensions:

Defined Benefit, Defined Contribution and a ‘hybrid’, the Cash Balance Plan.

Defined Benefit (DB) Pension

This is also known as a ‘final salary’ pension. “It is a type of workplace pension that pays you a retirement income based on your salary and the number of years you’ve worked for the employer, rather than the amount of money you’ve contributed to the pension.” Source: Pension Bee

Defined Contribution (DC) Pension

This is the most common type of pension. When you retire, the amount you have in your pension pot depends on how much you have contributed to the pension over time. It also depends on how much your employer contributed, the amount of tax relief received from HMRC and how your investments have performed.

Cash Balance Plan

Cash Balance Plans combine the features of both DC and DB pensions. They guarantee a minimum pension amount on retirement, and you have the freedom to withdraw the money however you wish. Source: MoneyHelper.org.uk

State Pension

Once you reach state pension age you can claim the state pension. Currently, the UK state pension age is 66 for men and women. If you were born after 5 April 1960, this will increase to 67 and may increase further to 68 due to increases in life expectancy.

You can use this calculator to calculate your state pension age.

The amount of state pension you get depends on your National Insurance (NI) contributions.

You generally need about 10 qualifying years on your national insurance record to get any state pension.

Check how many qualifying years you have here.

Basic State Pension

To get the full basic State Pension of £156.20 you need a certain number of qualifying years of National Insurance.

If you have less than the number of qualifying years required, you will get less than £156.20.

New State Pension

You can claim the new State Pension if you’re:

• a man born on or after 6 April 1951.
• a woman born on or after 6 April 1953.

The full new state pension is currently £203.85 per week. You’ll need at least 35 qualifying NI years to get this.

If you don’t have the full number of years, take £203.85/35 and multiply by the number of qualifying years that you have to calculate how much you will get e.g., you have 25 qualifying years, @203.85/35 x 25 = £145.61.

You can check your state pension forecast here.

Tax relief on your pension contributions

Before tax salary contributions

You can choose to pay a percentage or a fixed amount of your gross salary into your pension. This lowers your taxable income and therefore, the tax you pay.

Say you earn £50k and opt to contribute 10% of your gross income to your pension. You will pay £5k into your yearly pension, and HMRC tops it up by £1k.

From the table below, in the first column, you can see that you get £6k pension contributions and reduce your tax bill by £1k. So, you are £7k better off than if you hadn’t paid any pension contributions.

After-tax salary contributions

If your pension contributions are paid out of your after-tax salary, your pension scheme will automatically add basic-rate tax relief when you make a contribution. If you pay higher or additional rate income tax, you can reclaim further tax relief through your annual self-assessment tax return.

For example, a £100 pension contribution will cost:

• £80 if you pay basic-rate income tax of 20%, as you will get tax relief of £20.
• £60 if you pay 40% tax.
• £55 if you pay the top rate of income tax at 45%.

If you’re a non-taxpayer you can make a gross contribution of £3,600 which includes tax relief i.e., it will cost you £2,880.

The tax efficiency of pension funds means that the money will grow quicker and larger due to:

• extra money claimed via tax relief.

• the money is not being depleted by tax, as is the case with taxable investment accounts. The caveat is that there may be some tax charges depending on what the pension scheme invests in. For example, “Residential property held directly or indirectly by an investment-regulated pension scheme is subject to certain tax charges.” Source: HMRC Pensions Tax Manual.

Choosing a Pension

You need to consider how many years are left until retirement, where you live, your risk appetite, whether you are self-employed or an employee etc.

Determine which pension type, as described above, is available to you and suitable for your needs. For example, if you are self-employed and aged 21 you won’t qualify for auto enrolment into a workplace pension.

What investment choices does the pension plan offer? Do you want to invest in index funds, ETFs, shares, bonds, real estate investment trusts (REITs) etc.? Check the variety of choices available and their performance.

What is your risk appetite? Do you want to be aggressive in your risk approach or go lower risk?

Check the fees and charges that apply as they have a significant impact on investment return over time.

Do you want someone else to manage your pension or do you want to manage it yourself?

What is the inflation rate? Some asset classes perform better in high inflationary periods than others e.g., REITS generally perform better than, say, bonds.

What is your life expectancy? This is important as it will help you estimate how much you need in retirement and how long it needs to last. You can use a Life Expectancy Calculator to provide an estimate of your expected lifespan.

Withdrawal Strategy – How You Can Take Your Pension

Once you decide to retire, you need to decide how you are going to take the money from the pension fund in the most tax-efficient way. I strongly advise speaking to your tax advisor before deciding on which strategy or strategies you will employ.

You can tax a tax-free lump sum of 25% of the value of the pension pot. You then have another 6 months to start taking the remaining 75% which is taxable.

Potentially, you could take this 75% as cash and buy an annuity (fixed income for life) or invest it to get a regular income (flexi-access drawdown).

Further information can be found here.

Money Purchase Annual Allowance (MPAA)

When you first access your defined contribution pension scheme, this triggers the MPAA which replaces the standard allowance. The MPAA is £10,000.

Pensions – In Summary

When you make a pension contribution you are paying yourself multiple times: by you contributing to the pension, the employer contributes (if it is a workplace pension), you may get tax relief, and you pay less tax.

Choose a pension that suits your requirements and continue investing to ensure you have the type of retirement you want!

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DISCLAIMER: Inquisitive Finance operates on principles of exchange of knowledge, ideas and opinions and learning in the community. Your decisions are entirely your own responsibility, and I am in no way responsible for your actions. I am not a financial advisor. Whilst I strive to provide accurate and up-to-date information, I make no warranties or representations as to the accuracy or completeness of this information. Use common sense, do due diligence and where necessary, use the services of a licensed financial advisor, before making any financial decision and/or transaction.