Intro to Pensions - How do Pensions Work?

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We all know that pensions are important. No one needs to tell us that someday when we are too old to work, we will need a steady stream of cash to keep us going. 

For most Koody readers, retirement might seem ridiculously far away. Still, it's important to remember that if you want to live comfortably and enjoy life when you are much older, it pays to start planning now.

This post aims to steer you to relevant parts of the website and help you understand on a high level how pensions work here in the UK.

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So, without further ado, here's what we have lined up for you:

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A pension is a savings pot that you contribute to throughout your working life and spend from when you retire.

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The money saved in a pension is usually invested in stocks and shares by your pension provider, and you normally won't be able to access this money until you are at least 55 years old (increases to 57 in 2028).

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There are two types of pensions - defined benefit and defined contribution pensions. 

For our generation, the relevant pension type is the defined contribution pension. With a defined contribution pension, the onus is on us to build our own pension pots, which will then serve as an income source in retirement. 

Unlike a defined benefit scheme, which promises a specific income at retirement, the amount we might get from a defined contribution pension depends on how much we contribute throughout our lifetime, how our investments perform, and the lifestyle we choose at retirement.

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You can save as much as you like into your pension each year, but you will be taxed if you:

1. Contribute more than £40,000 in one year - this is your annual allowance, and you can usually carry forward any unused allowance for up to three years.
2. Contribute more than 100% of your earnings in one year.
3. Exceed your lifetime allowance - £1,073,100 in your lifetime.

The government will add money to your pension contributions in the form of tax relief (free money).

For every £80 you put into your pension, the government adds £20 - and you can claim an extra £20 if you're a higher earner.

You can think of tax relief as a refund of the tax you originally paid on your pension contribution, at your usual rate of income tax - 20%, 40%, or 45%. 

It's your pension provider who claims this tax relief at the basic rate and adds it to your pension. If you're a higher rate taxpayer, you'll need to claim the additional rebate through your tax return.

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1. Workplace pension and auto-enrolment
2. Personal pension
3. State pension
4. Lifetime ISA
5. Pension for the self-employed

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1. Workplace pension and auto-enrolment

A workplace pension is a way of saving for your retirement and is usually arranged by your employer. When you join a new company, your employer must enrol you into their workplace pension scheme if you meet the minimum requirement.

Once you are enrolled, both you and your employer must contribute a percentage of your salary into a workplace pension scheme.

The minimum your employer must contribute to your pension is 3% of your salary. And the minimum total contribution (you and your employer) must make is 8%.

See, Workplace Pension Scheme - Auto Enrolment
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2. Personal pension

‍‍Personal pensions are private pensions that you arrange yourself.

If you don't have a workplace pension, a personal pension could be a great way to save for retirement. And even if you have a workplace pension, a personal pension in addition to your workplace pension could be a great way to grow your retirement savings faster.

There two types of personal pensions - Self-invested Personal Pensions (SIPPs) and stakeholder pensions.

See, Best Pension Providers - Personal Pensions
Also see, Stakeholder Pension - Best Stakeholder Pension
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3. State pension

In addition to the personal and workplace pensions, you are entitled to something called the State Pension. This is free money from the government, and the amount you get is based entirely on your National Insurance record.

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The earliest you can get the State Pension is when you reach the State Pension age. If you're currently aged between 20 and 39, your State Pension age will likely be 68. You can double-check that number here.
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4. Lifetime ISA

Another way to save into a pension is with a Lifetime ISA. A Lifetime ISA is open to adults aged 39 or younger and lets you save up to £4,000 a year towards your first home or retirement. The government will add a 25% bonus to your savings every year up to a maximum of £1,000 per year.
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5. Pension for the self-employed

If you are self-employed, a solo-founder, or the sole director of a company with no other employees, you will not be automatically enrolled into a pension when you start working for yourself. 

It is up to you to sort out your pensions. This shouldn't scare you. It's pretty easy to open a pension pot, and saving into one is just as simple as transferring money from one account to another.

See, Self-employed Pension - Best Pension for Self-employed People

Credits 

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