How Personal Pensions work
personal pensions help grow your wealth
The fundamental idea behind a personal pension plan is simple.
You put money into a savings fund and it hopefully grows in value. At retirement, you have several options which are usually designed to replace some (or all) of your employment income.
These notes apply to an individual who is looking to establish a personal pension or stakeholder pension.
What About Other Forms Of Savings?
Obviously, if you are serious about retirement planning, you should not necessarily concentrate all your savings into the one area of personal pensions. However, personal pensions will certainly form part of your overall strategy.
How to save into a personal pension
You can typically save into a pension plan in one of two ways:
Regular instalments
The pension payment can be taken automatically each month by Direct Debit. Once you start making regular contributions in this way, and become accustomed to the regular payments going out of your account, you may find it easier to plan your monthly budget.
One-off investments
It is your responsibility to make sure that the contribution is made.
A combination of both
This provides both the discipline of regular investments and enables one-off investments to also be made so that the best use of the available tax relief can be made.
Tax Considerations
Tax Relief
Tax relief is granted on pension contributions within allowable limits. Currently, the basic rate of tax is 20% and higher rate is 40%. The additional rate is 45%.
For individuals contributing to a personal pension or stakeholder plan, the contribution is made net of basic rate tax. If you invest £80 into a personal pension, the provider will add the remaining £20 and invest £100 on your behalf (claiming the tax relief back themselves from HMRC).
If the investor pays tax at higher rates, it is possible to claim back the marginal rate on some or all of the contributions via a tax return (higher and additional rates) or via a tax code adjustment for higher rate relief. In the example above, £100 is declared on the self-assessment tax return. The tax office will then credit you with the additional £20 of tax relief (so £20 of tax relief is paid into the pension plan and £20 is credited to the investor).
Self-employed investors also receive 20% tax relief immediately and claim any higher rates of tax relief via their tax return. As the income of a self employed person may be unclear until the tax year has ended, care should be taken to understand the effect on self-employed tax assessments when making pension contributions.
The tax treatment is dependent on individual circumstances and may be subject to change in future.
Restrictions on Payments
The total amount you (and your employer or other third parties) can save each year toward a pension, without suffering a tax charge, is limited to the ‘annual allowance’. The annual allowance for the tax year 2022/23 is £40,000 for most people (but can be less for those with high income). You may be able to carry forward unused annual allowance from the previous three years (ie. back to 2019/2020 for 2022/23).
In addition to the annual allowance, your personal contributions that are eligible for tax relief are limited to 100% of your earnings or £3,600 if greater. You can invest up to £3,600 per year gross in a personal pension (and still receive the 20% tax relief) even if you have no earnings. As the person making the contributions does not have to be the same as the person benefiting from the pension, this facility can be helpful in providing a pension for a non-working spouse – or for children and grandchildren as part of inheritance tax planning.
How Much Should I Invest?
You should invest as much as you can comfortably afford, as soon as you can, within allowable limits. You should not overstretch yourself. Most modern pension plans are flexible in terms of allowing contributions to be increased, decreased or temporarily stopped as circumstances dictate.
It is useful to try and link your contributions to salary. For example, if you have decided that you can afford £100 per month and you earn £20,000, a quick calculation will show this amounts to around 6% of salary. Try to at least maintain this percentage in future years.
You may also choose to calculate the level of savings necessary to achieve a certain level of income (in today’s terms) at your chosen retirement date. This target funding is then reviewed on a regular basis to account for revised objectives, investment performance and changing market conditions. Please contact us for assistance with this calculation.
State Benefits
The new State Pension is a regular payment from the government that you can claim if you reach State Pension age on or after 6 April 2016.
You can get the new State Pension if you’re eligible and:
a man born on or after 6 April 1951
a woman born on or after 6 April 1953
The full new State Pension is £185.15 per week (2022/23) a rise of 3.1%. How much you get will depend on your National Insurance record. You’ll usually need 10 qualifying years to get any new State Pension. Furthermore, you may need around 35 years to qualify for the full new State Pension.
The amount you get can be higher or lower depending on your National Insurance record. It will only be higher if you have a pre 6/4/16 National Insurance record including a certain amount of Additional State Pension.
What’s next?
If you are considering starting saving for your retirement, ask yourself:
Is the level of savings you are proposing realistic from a retirement and state pension perspective?
A pension is a long term investment. The fund value may fluctuate and can go down. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation.
Important information
This article (How Personal Pensions work) is intended to provide a general appreciation of the topic and it is not advice.
For more information please contact Centrad Limited on 01922 745400 or email enquiries@centradltd.com and we will be happy to assist you.
Article expiry: 06 April 2023