There are multiple benefits to contributing to your pension beyond just being a way of saving for retirement. Pensions are one of the most tax-efficient ways to grow your wealth and can also be used to effectively reduce your salary and protect you from a hefty tax bill if your annual earnings are over £100,000.
Here are our top 7 pension benefits
1. You receive tax relief on the contributions
If you contribute to your pension through an employer, you will generally make a full contribution without paying tax. This is typically done automatically through the payroll process.
If you make a personal contribution, your contribution will be grossed, receiving tax relief at the basic rate (ie. A contribution of £80 would receive tax relief of £20 in the fund, making a total contribution of £100). From there you can claim higher/additional rate relief if you are a higher/additional rate taxpayer.
2. Pensions can lower your tax bill
If you are earning more than £100,000, you will be subject to a ‘tax trap’ whereby you lose £1 of personal allowance (the first £12,570 of earnings on which you pay 0% tax) for every £2 of income over £100,000. This means that those earning £125,140 or more will have fully eroded their personal allowance, and the income between £100,000 and £125,140 is effectively subject to a 60% tax charge (40% income tax plus the loss of your personal allowance with its 20% tax saving).
By making pension contributions, you can reduce your overall adjusted income (total income minus pension contributions) so that it sits below £100,000, not only receiving tax relief on the contribution but also reinstating your personal allowance.
3. Your pension will enjoy tax-free growth in a fund
The pension fund will not be subject to dividend tax or capital gains tax within the fund meaning that you can enjoy the investment returns without worrying that tax charges will erode the growth.
4. You will have tax-free cash entitlement in retirement
Historically you might have heard the term ‘pension commencement lump sum’, or ‘25% tax-free cash’, that was generally available on most Defined Contribution pension pots. Recent regulatory changes mean that going forward this will be known as the ‘lump sum allowance’, and will generally be 25% of your pension fund, up to £268,275. The remainder of the fund will typically be subject to income tax at your marginal rate as and when you withdraw it. Because of this, it’s important to consider the most tax-efficient way to plan for your income strategy in retirement.
5. Pensions are generally free from inheritance tax
Pensions are typically excluded from estate calculations on death, making them a great product for estate and legacy planning.
6. You are likely to have provision through your employer
Almost all employers have an obligation to provide you with a pension, and actively make contributions to this pension, providing you with free money to build your pension fund for retirement.
If you elect to contribute to a pension via salary sacrifice, you and your employer can also save on national insurance contributions, the value of which can be further invested into your pension to increase your contribution or can be used to increase your take-home salary.
Several online calculators can show you the impact on your take-home pay by increasing your employee pension contributions by 1 or 2%; you may find that while this does not have a significant impact on your net income, over time, this could have a dramatic impact on the value of your pension fund.
7. Pensions are a long-term investment
It can be easy to consider your short-term savings objectives, being put off by the inability to access pensions until age 55 (increasing to age 57 in 2028) however, by saving early, you also benefit from compounding.
Compounding is where any gains made on the investment are continually reinvested in the fund and allowed to accumulate over time. This means that by contributing to your pension, not only are you making money from the initial investment made by you and your employer, but you are also benefitting from growth on the accumulated interest.
Let’s see how this works in practice:
Take a look at the following three scenarios:
- A 20-year-old invests £200 per month for 10 years (total invested = £24,000)
- A 30-year-old invests £200 per month for 30 years (total invested = £72,000)
- A 40-year-old invests £400 per month for 20 years (total invested = £96,000)
Assuming an annual investment return of 7%, who do you think at age 60 ends up with most?
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If you would like to review your pension strategy, please get in touch and we would be delighted to have a free 30-minute chat.
