How does investing in a pension benefit you?
Pensions have so many intricacies and complications that it's easy to miss the most significant pension benefits: they are an incredibly tax-efficient way to save for your retirement.
How the Government Tops up your Pension
The government gives you tax relief on your pension contributions. This means that any income tax you would have paid on your earnings goes to your pension instead. It also means that every time you contribute to your pension pot from your net income, you receive a government top-up to make you ‘whole’ again – this is particularly relevant for freelancers and other self-employed people.
If you add money to a personal pension the government always automatically adds 25% to your pension pot. If you are a higher or additional rate tax payer you are able to claim back even more money in your tax return (which can amount to an effective top-up of nearly 82% for the highest earners). This type of tax relief is known as ‘relief at source’.
If you are saving into a pension through your employer your contributions are normally taken directly from your gross pay which reduces your income tax bill (known as a ‘net-pay scheme’), so the tax advantage is implicit.
In addition to income tax relief, any gains you make on your investments (or dividends you receive from them) are also free from tax. This type of relief is not always available on regular investments outside of your pension.
How This Works in Practice
Let’s say you contribute net £500 per month after tax relief is factored in (which is a gross contribution of £833.33) on an income of £60,000, from your 30th birthday until you retire at age 55. Let’s assume your contributions grow at a rate of 6% per annum. By retirement your pension pot would be worth roughly £320,000 – strikingly, nearly £130,000 of that would be purely due to the tax relief the government added on top of each contribution, and the growth on that relief.
Note that there are some limits to how much tax relief you can enjoy. We'll outline these below.
- The annual allowance is how much you can contribute in a tax year before you stop benefitting from tax relief.
- You can normally contribute as much as you earn with a cap at £40,000 (if you have no income you can still contribute £3,600).
- If your adjusted income (regular income plus pension contributions) exceeds £240,000 your annual allowance starts being reduced by £1 for every £2 of additional income, down to a minimum of £4,000; this is known as the tapered annual allowance.
- If you have unused allowance from the previous three tax years you can use it in the current year (provided you have sufficient earnings to cover these additional contributions – remember you can’t contribute more than 100% of your earnings); this is known as ‘carry forward’.
- Note that limits are expressed as gross contributions – so if your annual allowance is £40,000 and you are a basic rate taxpayer, this actually means you can only contribute a net £32,000 as the government automatically adds a further 20% (or £8,000),
- The lifetime allowance determines how much you can draw from your pension pot at retirement before you start getting hit with higher tax charges; the amount is £1,055,000 for the 2019/20 tax year and is set to rise in line with inflation.
- While you don’t need to stop contributions once you start drawing benefits from your pension, you don’t benefit from tax relief if you make contributions after the age of 75.
- If you start to take money from your defined contribution pension, the amount you can pay into a pension and still get tax relief reduces. This is known as the Money Purchase Annual Allowance (MPAA) and currently stands at £4,000 (2019/20 tax year).