5 key pension tips

Pensions are a hugely valuable yet little understood mechanism to meet your retirement goals. In Pension Awareness Week, an annual campaign to raise awareness of the importance of pensions and improve people’s financial wellbeing, we look at the top mistakes people make.

1. Underestimating the value of pension tax reliefs

The first pension mistake to avoid is neglecting to join and pay into one in the first place. Not only is opting out of your workplace pension akin to taking a voluntary pay cut, as it frees your employer of the legal obligation to pay into it too (only a small number of employers contribute regardless), but you also miss out on some of the government’s most generous tax reliefs.

All pension contributions are restricted by the annual allowance, which is currently £60,000 and personal pension contributions are restricted by 100% of your net relevant earnings.

Secondly, all savings and investments in a pension wrapper grow completely free of tax on both gains and income. Typically, the only tax you pay is on income you withdraw from your pension once you are retired.

Finally, pensions currently sit outside of your estate for inheritance tax purposes, making them a great tool for legacy planning (albeit this is not their intended purpose). If a person dies before 75, their pension can also be inherited free of income tax.

Some employers offer ‘salary sacrifice’ (subject to HMRC’s rules and regulations). This isn't a tax relief as such, but by reducing your taxable earnings you also reduce the amount of income tax and national insurance you need to pay. But your future state pension and other benefits may be impacted.

For instance, in England and Wales the marginal tax rate on income between £100,000 and £125,140 is 60% because you lose £1 of your £12,570 tax-free personal allowance for every £2 of income above £100,000. Paying more into your pension to keep your taxable income below £100,000 can prevent your marginal tax rate jumping from 40% to 60%. A pension contribution can also be used to avoid or reduce the child benefit higher-income charge on incomes between £60,000 and £80,000. But don’t forget there are annual limits on the amount that can be paid into your pension.

“The government offers enormous tax benefits to incentivise people to pay more into their pensions, which is why as financial advisers we champion it as such a fantastic way to save for retirement,” says Matt Law, Independent Financial Adviser at Ascot Lloyd. “A lot of people underestimate just how generous these tax benefits are or don’t understand how they work.

“With the power of the tax reliefs and compound interest combined, it makes a lot of sense to pay into your pension as early as possible and contribute as much as you can, (within the limits), throughout your life. But even if you’re just a few years away from retiring, a last gasp cash injection into your pension can make a big difference. At a time of life when people are often at their highest earning potential and lowest outgoings, a large one-off contribution, subject to the rules on tax-free contribution limits in any given year, can really bolster your retirement funds.”

2. Forgetting to claim your tax relief

The ways in which the tax relief on private pension contributions is claimed differs depending on your income and the type of pension contribution made

For some people tax relief is applied automatically by the employer before they are paid. For others, including every person contributing to personal and stakeholder pensions and some with workplace pensions, they need to claim all or some of the higher rate tax relief on their self-assessment tax return.

“Some people aren't aware of the need to claim tax relief themselves and are basically missing out on free money every year by not doing so,” says Law. “It’s really important firstly to understand how your particular pension scheme works when it comes to tax relief and secondly, if you do need to claim in your self-assessment, to do so before the deadline comes and goes.”

3. Not knowing about the money purchase annual allowance

There’s nothing to stop you, once you’ve started drawing from your pension, from continuing to work. Or as a lot of people experience, retiring only to get bored and want to return to work in some way.

What you need to be aware of, however, is the money purchase annual allowance (MPAA) which basically means your £60,000 annual allowance for pension contributions reduces to only £10,000 once you access the first £1 of income from a personal pension arrangement.

The MPAA applies to defined contribution pensions, not defined benefit schemes, and it is not triggered if you only withdraw your tax-free lump sum or part of it.

4. Rushing to withdraw your 25% tax free lump sum

The ability to take 25% of your pension savings (up to £268,275) as a tax-free lump sum is a tremendous benefit, but often people race to do this at their earliest opportunity (normally aged 55, rising to 57 in 2028) without putting careful consideration into if it’s in their best interest to do so.

If you don’t have a good purpose for that money, it can be more beneficial to phase your tax-free allocation into drawdown over a longer period of time, leaving more savings to grow in your tax-free pension wrapper in the meantime.

The decision to take or not take your tax-free lump sum can also have inheritance tax implications. Remember, pensions are currently exempt from inheritance tax whereas money in your bank or savings account, or even an ISA, is not.

However, if you are aged 75 or over and your beneficiary is your spouse, it might be beneficial for you to withdraw a tax-free lump sum before you die. Spouses are exempt from inheritance tax so will inherit all money outside of your pension totally tax free. If it remains in your pension your spouse will probably need to pay income tax on beneficiary drawdown because you died aged 75 or over.

Of course, if the tax-free lump sum is taken and inherited by your spouse, it will be included in your spouse’s estate (if unspent by the time they pass away) for inheritance tax purposes.

“These are often very complicated decisions and therefore you shouldn’t rush to take your lump sum without thinking it through,” says Law. “A financial adviser can help run through the scenarios to ensure you make the best decision for you and your family.

“If you wish to take a lump sum which exceeds your tax-free cap, consider staggering the withdrawals across two tax years. I had a client recently who wanted to take money out to buy a property. She's in the 20% income tax band and assumed that's the rate she’d have to pay on the withdrawal. She didn't realise it would push her into the higher threshold leaving her to pay 40% tax but splitting it into two withdrawals either side of April 5th reduced her tax liability.”

5. Not checking your pension provider’s rules or default fund

For many people their knowledge of pensions starts and ends with how much they pay in each month. But exactly how your pension can be accessed will depend on the rules stipulated by the pension scheme chosen by your employer, and this can have significant implications on your retirement.

For example, some pension schemes don’t allow flexible access drawdown and restrict you only to an annuity, which might not be appropriate for your specific retirement goals.

Meanwhile, the vast majority of people don't move their savings from their pension scheme's default strategy. These default funds often are not the best performing in the market and are certainly not selected based on your individual risk appetite and retirement goals.

The other thing is to ensure you understand how the scheme works in the event of your death, so it’s really important that you have told the scheme administrators who your intended beneficiaries are and that this information is kept up to date.

“Not all pension schemes are created equal and it’s really important that you know exactly how yours works,” says Law. “I often ask people if they know what funds they are invested in and a lot of the time they say no. Do you know anything about your pension, when and how you can access it? No.

“The lifestyle funds used by many schemes reduce the exposure to equities typically in the five years prior to your selected retirement date, which isn’t always appropriate to clients, but so many people are just not aware of this.

“One gentleman approached us recently who is turning 75 this year and his pension provider said they are going to automatically pay out an annuity to him. But he doesn’t want an annuity – he wants the flexibility to draw down from a pension as and when he wants. He turns 75 in October so we’re in a race against time to transfer his pension to a different provider that does allow flexi access drawdown. Many people don't know this about their policy until it's too late.”

Pensions are complicated and mistakes can be costly. Speaking to an independent financial adviser about how pensions fit into your own retirement strategy can prove invaluable.

If you would like to speak with someone about pensions and retirement planning call your adviser directly or, book a call back with our client services team.