Top 5 things you need to know about pensions

Pensions form the bedrock of a successful retirement – here are the key points to understand.

Freed of the obligation to work, retirement should be one of the most enjoyable periods of your life. But filling your time with what you want to do, such as travel, hobbies, and memorable experiences with your loved ones, while also keeping up with day-to-day bills, of course, requires money.

The amount of State Pension you receive at the age of 66 (rising to 67 in 2028) will depend on your National Insurance record, but even if you get the full amount, it is unlikely to be enough to fund the comfortable retirement lifestyle you want (the Pensions and Lifetime Savings Association Retirement Living Standards research suggest a couple will need £54,500 net of tax (£37,300 for a single person) for a comfortable retirement^[1]. That will depend on other forms of income, which is what makes the pension opportunities afforded to you during your working life so vital.

With a good plan in place, and a firm understanding of how money is taxed going in and coming out of pensions, you can make the most of life now with the peace of mind that you will be able to do the same in retirement. In this guide, we outline five key things to know about pensions.

Why do I need to save into a pension?

The first thing to understand is why pensions are such an important part of retirement planning in the first place. When your retirement savings are just left in your bank account, the value erodes over time due to inflation. Investing that money instead will help its value grow, but doing so in a general investment account will make any gains, income or dividends received each year liable for tax. Pensions provide a tax-free wrapper which means investments can grow and earn without triggering a tax charge, allowing you to enjoy the full benefits of compounded returns. When you wish to draw upon those pension savings, it will be taxed as income excepting for the portion available as a tax-free lump sum. .

Getting more from your employer – and the government

Thanks to auto-enrolment rules introduced over the last decade or so, all organisations now have to contribute to the pensions of their employees. To qualify, you have to contribute 5% of your qualifying earnings^[2] to your pension. Your employer will, in turn, contribute at least 3%. Some will contribute much more. You can opt out of contributing to your pension, but this would be akin to turning down free money because your employer will also cease making their contributions.

Understanding allowances

While there are plans to remove the additional tax penalties that apply to pensions savings in excess of the current Lifetime Allowance (LTA) of £1,073,100 when accessing the benefits or at so called ‘benefit crystallisation events’, though currently the charges of up to 55% have been reduced to 0%. From next tax year it is anticipated the LTA limit will be removed, but the cap on the maximum amount of tax free cash that can be taken will remain £268,275 or 25% of the fund if lower. At present the legislation to enact this is in the process of being drafted and a number of areas of uncertainty remain given how this has been written and may therefore be subject to changes in the final rules. In addition, in the budget announcing this change the opposition party made clear that they did not support the removal of the limit. So, it remains to be seen if this endures. 

There is an annual limit on the amount of contributions on which tax relief can be applied (and a maximum age of 75)– and that is now £60,000 per year. For defined contribution plans, which all private pensions and most workplace pensions are, the allowance is based on the total contributions from you, your employer, the government, and anyone else. Even if you’re not in paid employment you can contribute up to £2,880 into a personal pension and still get tax relief of 20% which tops up the contribution to £3,600. You can even save into a pension scheme for your children or grandchildren.

If you have a defined benefit pension, as many public sector workers do, it’s based on the increase in your pension benefits that year. For all pension types, if you didn’t use your full allowance previously, you can carry forward any unused amounts from the last three tax years.

Accessing your pension

You can start taking money from a workplace or private pension from the age of 55 (rising to 57 from 2028). The first 25% of your pension income will typically be tax-free, with the remainder taxed based on normal income tax bands. If you have a defined contribution pension, you can normally take your 25% tax-free amount as a lump sum if you wish to do so. With defined benefit schemes the tax free cash benefit may be accrued separately from the income benefits and so will tend to be fixed e.g as three times the annual income, or you have to elect to exchange some income level for the lump sum (known as commutation) the schemes vary as to how generous they are with this.

The Financial Conduct Authority has stated that most people who have defined benefits (sometimes call final salary or career average schemes) are best advised to stay in them. This is because the guaranteed nature of these and the fact they normally also include some inflation protection should not be given up lightly if at all. There are very limited situations where it can make sense to transfer and advice must be taken where defined benefits are worth £30,000 or more as a transfer value. Your Ascot Lloyd Independent Financial Adviser will be able to advise how pension transfers work and whether advice in this area may be appropriate.

Protecting your legacy

While many people only think about pensions in respect to retirement planning, they are currently also an excellent vehicle for protecting your legacy from inheritance tax. That's because any money in a pension wrapper does not form part of your estate. If you have a defined contribution pension, any unspent money in your pension pot can, at present, be passed onto family when you die without triggering an IHT charge.

If you are in a defined benefit scheme, typically a proportion, half is common, of your pension income will go to your spouse, when you die and taxed at their marginal rate. Some schemes also offer additional children’s pensions whilst in full time education and sometimes up to age 23. Exactly who it goes to and how much will they get will depend on your specific scheme's rules which your scheme administrators will be able to provide you with.

^[1] Home - PLSA - Retirement Living Standards

^[2] Qualifying earnings are all earnings between a lower and upper limit set by the government and reviewed each year. In 2023-2024 the lower limit is £6,240 and the upper limit is £50,270. Qualifying earnings include salary, wages, commission, bonuses, overtime, statutory sick pay and statutory parental leave pay (maternity, paternity and adoption pay).

Ascot Lloyd’s team of experienced Independent Financial Advisers can help you create a pension plan that meets your key retirement goals. Click here to book a free callback.