Millions of people don’t really understand how pensions work, or put off thinking about them when times are hard and money is tight
Along with mortgages, pensions are among the most important financial commitments you’ll ever make in your life. Yet millions of people don’t really understand how they work, or put off thinking about them when times are hard and money is tight.
I have to say, I really sympathise with this view. I had to study pensions and how they worked when I took my financial planning qualifications back in 1857 and I found the whole subject distinctly challenging.
The financial world has changed significantly since I did those exams. The good news is many businesses that offer advice and support around pensions have recognised how important it is to help us understand how pensions work and how to make the most out of them.
But for many people, pensions are still a bit of a mystery. So, I’ve recruited consumer finance specialist Sarah Pennells, from Royal London, to help answer some of the biggest financial urban myths around pensions.
Pensions explained
There are three main types of pensions:
- The state pension. This is the pension you get from the state (or government) and is based on your National Insurance contributions over your lifetime.
- Your workplace pension. This is the pension you have through your workplace. Your employer will pay into it, and you can usually contribute extra into it as well. The pension provider should send you a statement every year showing you how it’s doing – even after you’ve left the business.
- A private pension. These are pensions you set up yourself. You get the same tax benefits as a workplace pension, and they are a really useful way to save for retirement – especially if you are self-employed.
There are loads of different types of private pensions, which is why taking advice before signing up to one is a must. Before you fork out cash though, have a look at the free options on the government-backed and impartial Money Helper website: https://www.moneyhelper.org.uk/en
11 pension urban myths
1. You’re better off putting your money in a savings account for your retirement.
Pensions are without a doubt one of the most tax efficient ways to save. That’s because you get tax relief on money you pay (ignore the jargon, I’ll explain this in a second!) and money in a pension grows tax free.
Tax relief simply means that the government tops up any money you pay into your pension. However, research carried out by Royal London showed that over a third of people with a pension (36%) didn’t know that they got this tax top-up on the money they pay in. If you’re a basic rate taxpayer, the tax relief means that every £100 you pay into your pension will only cost you £80 (this is the kind of maths I like!)
Also, while your money is in your pension, it grows tax free, and you can normally take 25% out tax-free as well (more on that later).
2. The money employers pay in isn’t worth it
This is worth spending a bit of time on. If you’re an employee, you will get an additional bump up to your pension in the form of employer contributions, which you won’t get if you put money into, for example, a savings account.
If you are 22 or over and earn more than £10,000 a year (from each job, if you have more than one), you will automatically be placed into your workplace pension scheme when you start a new job. Your employer must pay the equivalent of a minimum of 3% of your salary into your pension (this is money they pay, it doesn’t come from your salary) and you have to pay in around 4% of your salary to your pension. Then the government tops this up by another 1%.
Some employers pay in more than this minimum amount of 3% of your salary as well. You can find out more about what goes into your pension here: https://www.gov.uk/workplace-pensions/what-you-your-employer-and-the-government-pay – but why not just ask your HR team how this works in plain English?
3. It isn’t worth saving a small amount in a pension when you are young
Even if you can only pay a small amount in to a pension, it’s worth doing, thanks to the wonders of ‘compounding’.
Compounding is the process over time where the money you invest generates a return and the investment plus the return is combined into one. You then get a return on the whole amount. Over time, the longer you invest, the more that money can potentially grow. Think of a snowball, running down a hill and growing in size. *Caveat alert!* Pensions involve investments and can go down as well as up.
If you decide not to start saving when you are young, then you will need to pay a lot more a month when you are older to match the amount you would have earned if you paid in when younger.
4. You can’t change your workplace pension contributions
This is definitely a myth! You can pay more than the minimum amount of 4% of your salary by increasing the percentage you pay monthly or paying a lump sum into your pension. You might think your outgoings are too tight for lump sum payments, but if you get a bonus, why not consider adding that to the pension?
It’s also worth asking if your employer matches any extra money you pay into your pension. Some will do this, pound for pound, up to a certain limit. If your employer does this up to, say, 8% of your salary, and you increased the amount going into your pension from 4% to 6% of your salary, then your employer would also pay in 6%. Extra money going straight towards your retirement – happy days!
5. Only the person who has the pension can pay into it
Nope – you can pay into someone else’s pension for them. The person who has the pension will receive the tax relief (and can claim higher-rate tax back if they are a higher rate taxpayer).
You might think this is pretty rare, but you’d be surprised. Some people choose to pay into a pension for a spouse or partner that isn’t working, or for a child or grandchild. You can’t go mad though. The most that can be paid into a pension is £2,880 a year, which becomes £3,600 when tax relief is added.
*Free extra pension fact!* Anyone can have a pension – including under 18’s.
6. You can take money out of your pension before you’re 55
This is the question I get asked the most about pensions, especially during the cost-of-living crisis.
Normally, you have to be aged 55 or over to take money out of your personal or workplace pension and this is rising to 57 in April 2028. However, there are a few specific circumstances when you could potentially take money out of your pension earlier.
If you are retiring early because of ill-health, then you might be able to take money from your pension before you’re 55. Your pension scheme provider will talk you through the evidence you need. If you have a terminal illness and have less than a year to live, you can take your pension benefits tax-free (as long as you’re under 75). There are also some exceptions for those who are in certain occupations like police officers or in the armed forces.
7. You have to stop working to receive your pension
To explain this, I’ll talk about defined benefit (DB) pensions, which guarantee a retirement income, and defined contribution (DC) schemes, which don’t, as they are pots of money saved for later.
With a pension pot (DC) type of pension, you don’t have to stop working in order to take money out of it.
But if you are in a DB scheme, for example, if you work in the public sector, you may get a reduced rate if you retire early to reflect the fact you will need the money for longer.
8. You have to stop paying into pensions when you start taking money out of your pension
You can continue to pay money into a pension even if you’ve started to take money out. However, there are limits to be aware of.
If you’ve taken money out of your pension that’s taxable, either as a lump sum or as income payments, you may trigger a rule (yikes – more jargon – it’s called the money purchase annual allowance, or MPAA) which limits the amount that can be paid into your pension to £10,000 a year (this includes your contributions, your employer’s contribution and tax relief).
There are lots of situations where this limit doesn’t apply. For example, if you take out tax-free cash and buy an annuity, or if you start getting your pension payments from a defined benefit (final salary type) pension.
9. If you have more than one pension, you can only take tax-free cash from one
If you have more than one ‘pot’ type of pension, you can normally take up to 25% tax free cash from each of them. There are limits on how much tax-free cash you can take, but most people don’t have enough in their pension(s) to worry about them.
You don’t have to take your tax-free cash in one go, either. Many pension pot (defined contribution) pension schemes will let you take your tax-free cash in a series of payments.
10. The state pension isn’t taxable
This one’s been in the news a bit lately. The state pension is taxable, but it’s paid to you without the tax being deducted. Since April 6th, the full new State Pension is around £12,000 a year, which is over £550 less than your personal allowance (the bit of your earnings that you don’t have to pay tax on). So, if you are receiving payments from another pension, such as a workplace or personal one, it’s likely you will have tax to pay. This tax is taken from your workplace or personal pension. More here: https://www.gov.uk/tax-on-pension/how-your-tax-is-paid
11. Pensions are restrictive and you can’t take money out until you’re 65
There’s a lot of confusion about when you can get your hands on your pension and how much money you can withdraw without paying tax. The rules depend on the type of pension you have, but you can get your hands on your pension much earlier than the state pension. With the most common type of workplace pension (defined contribution) you can take money out after you turn 55 (this is rising to 57 from April 2028). You can take 25% of the pension tax-free at this point.
With this type of pension, you can also choose how you take money out of it. You can take cash lump sums directly from your pension, use it to buy a guaranteed income for life (called an annuity) or take an income from it.
That flexibility means you can take more money from your pension when you need it, and less when you don’t.
- Martyn James is a leading consumer rights campaigner, TV and radio broadcaster and journalist. Sarah Pennells is the consumer finance specialist at Royal London.
