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What is a pension and why are they so valuable when saving for the future?

Your pension is one of the most tax-efficient and effective ways to save and invest. Find out why pensions can be so useful when you're saving for the future.

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Whether you’re early on in your career or you have an eye on life after employment, setting money aside and saving for the future is often a priority throughout your working life.

A pension is arguably one of the most effective ways to do this. You might have been automatically enrolled into your employer’s pension scheme, or you might have decided to start a fund for yourself.

Either way, thanks to the various tax advantages and potential to generate returns on your money, your pension can be a hugely useful tool in saving for retirement.

Yet despite how useful pensions can be, research from the Money and Pensions Service [1] shows that around half of the working age population don’t feel they understand enough about pensions to make decisions about saving for retirement.

So, read on to discover what a pension actually is, why they’re considered to be so tax-efficient, and how the different types of pension work.

A dedicated savings pot designed for retirement

Pensions are essentially a savings and investment pot specifically for retirement. In most cases, the amount you’ll have available in your pot in later life is determined by how much you pay into it – although there are some variants in how the schemes operate. You can find out more about this below.

Since new legislation came into place in 2015, you’ve been able to access your pension from the “normal minimum pension age”. This is currently 55, and set to rise to 57 in 2028.

You’ll be able to take the first 25% of your pot tax-free at this age. The rest will normally be subject to Income Tax at your marginal rate, depending on how much you withdraw.

Pensions are considered to be tax-efficient for savings and investments

Pensions are generally considered highly tax-efficient for two main reasons.

Firstly, your money will be invested in a range of assets, with some of your money often held in cash, too. Crucially, any growth your money generates – whether that’s interest on cash or investment returns – will be entirely free from Income Tax and Capital Gains Tax (CGT).

The fact that your money is invested for so long can be highly advantageous, too. This gives your wealth the opportunity to grow over a significant period of time.

Bear in mind that returns are not guaranteed and you could get back less than you invest.

Secondly, you can receive tax relief on your contributions at your marginal rate of Income Tax. In essence, you’ll see the Income Tax you would have paid on your money subtracted and added to your pot instead.

This means that a £100 pension contribution technically only “costs”:

  • £80 for basic-rate taxpayers
  • £60 for higher-rate taxpayers
  • £55 for additional-rate taxpayers.

One other potential tax benefit of your pension is that it will typically fall outside the value of your estate for Inheritance Tax (IHT) purposes.

As a result, your loved ones may be able to inherit it without paying IHT. However, they may have to pay Income Tax depending on how old you are when you pass away.

You can tax-efficiently save up to £60,000 into your pension each tax year

As tax relief is such a valuable benefit, there are limits as to how much you can tax-efficiently save into your pension.

Each tax year, you can receive tax relief on your pension contributions up to a limit called the “Annual Allowance”. In the 2023/24 tax year, the Annual Allowance is the lower of £60,000 or 100% of your earnings.

It’s important to note that you may have a lower Annual Allowance if you have a high income. In this case, you may be subject to the Tapered Annual Allowance, which could reduce your tax-efficient savings threshold to a minimum of £10,000.

Similarly, if you have already flexibly accessed your pension savings, you may be subject to the Money Purchase Annual Allowance (MPAA). This may also reduce your Annual Allowance to a minimum of £10,000. Ask your adviser about this to find out more.

There are various kinds of pensions that you may have

Over time, pensions and the associated legislation have changed quite a lot. As a result, there are now various different kinds of pensions.

Defined contribution and defined benefit schemes

One of the most important distinctions is whether your pension is a defined contribution (DC) scheme, or a “defined benefit” (DB) scheme.

These days, most pensions are DC schemes. This means the amount of money in it at the end is determined by how much you put in throughout your career. In retirement, you then draw as much or as little from your pot as you like.

This differs from “defined benefit” (DB) schemes, which you may have if you worked for a large employer in the past or are currently in a public sector role. These pay a guaranteed income in retirement, with the value determined by factors such as how long you worked for your employer.

Beyond this differentiation, the other label that might matter to your pension is whether it is a workplace or private scheme.

Workplace pensions

Subject to certain age and earnings limits, your employer will be legally obligated to enrol you in a workplace pension scheme.

When you’re in this scheme, you must pay a minimum of 5% of your earnings (made up of 4% from your salary and 1% tax relief) into your pension.

Your employer must top this up with a minimum 3% contribution. They may offer more than this as an incentive, but they do not have to. Employer contributions also count towards your Annual Allowance.

Workplace pensions can be hugely valuable, as the scheme will typically be managed by a provider and invested on your behalf. That means your money – including the additional contributions from your employer – will be invested, giving it the opportunity to grow over time.

Most workplace pensions these days are DC schemes. That said, if you work in a public sector role, such as a civil servant or a teacher, you may have a DB pension. Check with the scheme provider to find out what kind of pension you have.

Private or personal pensions

Aside from your workplace scheme, you may also have a private or personal pension scheme. This will essentially be the same as your employer’s scheme, in that you can contribute money to your fund and receive tax relief.

The main difference is that you won’t necessarily receive your employer’s contributions – you can ask your employer to pay into a private pension rather than the workplace scheme if you prefer, although they’re not obligated to do so.

Usually, your pension investments will be managed on your behalf by the provider you have chosen to start the pension with. That said, there are also other forms of pension in which you select the investments yourself, such as a self-invested personal pension (SIPP).

Bear in mind that you’ll need to be confident in your ability to choose investments if you want to save in a SIPP. Making mistakes with these investments now could be costly in retirement.

Get in touch

Want to find out how to make the most of your pension? Get in touch with a financial adviser.

Please visit our contact page or speak to your adviser.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.

[1] 05.09.2023 UK Adult Financial Wellbeing Survey 2021: Future Focus Money and Pensions Service

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Benchmark Financial Planning is an Appointed Representative of Best Practice IFA Group Limited which is authorised and regulated by the Financial Conduct Authority, the registration number is 223112. Registered office: Broadlands Business Campus, Langhurst Wood Road, Horsham, West Sussex, RH12 4QP. Registered in England and Wales No 07572431.

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