A pension is an investment proposition that allows you to build up long-term savings with a number of tax advantages.
For a start, you do not pay income tax on the part of your salary you contribute to your pension.
For example, if you earn £50,000 more than the annual earnings exemption – the amount the government lets you earn before it starts to tax you – and you pay £5,000 into your pension in a certain year, you will only pay tax on £45,000, not on £50,000.
You can invest up to the value of your annual salary on such a basis, with a limit of £50,000, although this is coming down to £40,000 in April. If you wish to invest more than this, you have to pay tax at your usual rate on the excess.
Once the money has been invested in a pension scheme, any gains that the investment makes and any income it generates are also tax-free.
There is, of course, a catch. When you eventually start to draw down your pension, the Government will tax you. Although the income is tax-free on the way in, it is not on the way out.
Although it may seem like the Government is taking with one hand what it has given with the other, there is a benefit to this process.
It is possible that whatever you earn now will be taxed at a higher rate than it will be when you retire, as you are unlikely to be able to save enough to produce an income equivalent to your current salary.
In that case, rather than paying tax on your contributions at the higher rate – currently 40 per cent – you could end up paying it at the basic rate of just 20 per cent.
As there are higher tax thresholds for people over 65, you will also be taxed on less of the money than if you simply put it into your bank account. This benefit will be felt even by basic-rate taxpayers. What about if I want to get the money out earlier?
On top of this, if you wait until you are 55, you can draw down 25 per cent of your pension fund in a tax-free lump sum, although you will of course be reducing the amount available to you when you retire, and any gains the money would have made had you left it invested for longer.
There is a lifetime limit of £1,500,000 (£1,250,000 from 2014) on contributions you can make to your pension, and this is taxed heavily when you draw the money down. However, this won’t be relevant to the vast majority of people. What is automatic enrolment?
Under reforms carried out by the current Government, all companies will be required to offer a pension to their employees, although workers will be able to opt out if they choose.
This is being introduced in stages, with the largest companies the first to be required to offer the schemes. Many companies have been doing so for years already.
The minimum salary contribution has been fixed at 8 per cent, with a minimum of 3 per cent to be paid by the employee, 1 per cent by the state in the form of tax relief, and the remaining 4 per cent by the employer.
However, the average employer contribution is currently 6 per cent, and these extra contributions are the key advantage of such schemes.
It is possible to make extra contributions to your pension in lieu of taking salary, although it is the employer’s choice whether it chooses to match these. Is it any better than an ISA?
Some people may be tempted to invest in an ISA rather than a pension. The investment has similar tax breaks on internal gains, although without the tax relief on the way in.
An ISA is more flexible as it allows you to withdraw your money whenever you like.
However, if your employer is offering to contribute to a pension scheme, you should consider these extra contributions before you turn it down. Your ISA would have to do very well to make more than the extra contributions of your employer.
What is a SIPP?
A self-invested personal pension (SIPP) is a type of product that is less restricted in terms of what it can invest in and one that is becoming quite popular.
Whereas a traditional pension may use a limited range of funds from the stable of the pension provider itself, a SIPP is not limited in this way.
This is useful for two main reasons: firstly because your pension provider may not be the best fund manager out there and secondly because if you have a limited range of funds, then you cannot switch if one starts to underperform.
However, this option may not be offered by your employer’s scheme – at least while you are at that company.
Your employer chooses the scheme it pays contributions into. SIPPs are starting to become as popular for employer schemes as they are for private pensions, but whether your employer is happy to pay into a SIPP is up to them.
Once you leave that employer you can move your pension into a SIPP if you wish.
The main drawback to these schemes is that they require a lot more effort to manage. You are responsible for fund selection, meaning that taking your eye off the ball is not an option.