Six things you need to know about pensions

Retirement can seem like such a long way off, it can be hard to prioritise a plan for your future. However, setting up a pension plan is one of the most important financial moves to protect your future and it really is a case of ‘the sooner the better’. Pensions set you up for later on in life and give you a livelihood when you’re no longer working, but it can be tricky to get your head around them.

These are the six things you need to know about pensions that can help you make your first steps into building your financial resilience for the future.

1. What is a pension plan?

A pension plan is a pot of money you and your employer pay into that you can draw money from when you retire.

2. How do pensions work?

The two types of pension schemes you need to be aware of are the defined benefit pension schemes and defined contribution pension scheme.

The defined benefit pension scheme means you’ll get a specific income when you reach the scheme’s retirement age. This income is worked out by taking into account your salary and the length of time you have worked. You may have to pay contributions but your employer will also pay contributions on your behalf.

The defined contribution pension scheme means what you get when you retire is not specified in advance. Instead, you build up your own pot of money by paying in money each month which is then invested. 

3. What is auto-enrolment?

Auto-enrolment now requires employers to offer employees a pension and to automatically enrol you on the scheme and crucially to contribute on your behalf. From April 2019 the minimum employer contribution level increased to 3% but under auto-enrolment total contributions must be at least 8%.

4. What’s salary sacrifice?

Paying into a pension as a taxpayer gives you a tax break. But for an extra boost, you should consider salary sacrifice. Salary sacrifice applies to a number of workplace benefits such as childcare vouchers or the cycle to work scheme, not just pensions.

As this comes out of your pre-tax salary and straight into your pension you pay less national insurance.

5. How much should I put in my pension?

With auto-enrolment pensions, there are minimum contribution levels but if you can afford it you should contribute more. The general rule for retirement is put as much in as possible, as early as possible.

A good rule of thumb is to take the age you start your pension and halve it. Then put this % of your pre-tax salary into your pension each year until you retire. So someone starting their pension aged 30 should contribute 15% of their salary for the rest of their working life. Don’t forget this includes your employer contributions so you only need to fund the rest.

There’s not really a limit for how much you can put into your pension, only the amount of tax relief you’ll get for putting money into a pension.

You get tax relief on contributions up to your annual earnings, so if you earn £19,000 a year but you put £20,000 into a pension you will only get tax relief on the first £19,000 of contributions.

There’s also a lifetime limit, this means there’s a lifetime allowance which has gone up to £1,073,000 for 2020 and 2021. If you go over this total in pension savings including what you earn interest you will face a tax charge.

6. What happens when I retire?

Once you have money in a pension it can’t be taken out until you are 55. At aged 55 you can take 25% of it as a tax-free lump sum, with the rest ideally providing an income for the rest of your life.

Remember, if you get approached before aged 55 to withdraw your pension it’s a scam. These scams were so damaging that the government banned cold calling about pensions in January 2019.

Once you’re over 55 you can take as much of your pension pot as you like but remember anything over the tax-free 25% will be taxed at your marginal rate.

These six common questions about pensions should be a good start to understanding them, how to set one up, and how much to contribute. Next step? Find out what pension you might already have and how much you are paying in.

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