What is a pension?

Regular income after retirement

At retirement, you can draw money from your pension pot or sell the cash to an insurance company in return for a regular income until death, called an annuity.

New rules announced in the 2014 Budget mean that once you reach 55, you can start accessing your pension pot, taking as much or as little as you like, whenever you like.

But it's important to understand how a pension affects your income.

Is a pension really worth it?

You get some tax back on the money you put into a pension, while gains from the investments you make with that cash are largely tax-free.
Tax relief on contributions

You get the tax back you've paid on all contributions, if you're under 75, subject to an annual allowance. This usually goes straight into your pension pot.

 What tax relief do I get?

If you pay the money into your pension yourself, or if it is taken by your employer from your pay packet, you automatically get 20% tax back from the Government as an additional deposit into your pension pot.

If you are a higher rate taxpayer you can claim an additional 20%, while top rate taxpayers can claim an additional 25%. If you are part of a workplace pension, you may not need to reclaim any tax if your employer simply deducts less tax from your pay packet.

If your employer puts the money straight in from your pre-tax pay then it's never taxed in the first place, so you still win.

How does the tax relief work?

If you get 20% tax relief, it doesn't mean you get 20% back of what you contribute.

Instead, the taxman works out your earnings on your contribution amount before tax was deducted. You then get back the difference between your contribution and your pre-tax earnings.

So when a basic 20% rate taxpayer invests £80 of their take-home pay in a pension, they'd have actually earned £100 before tax to come out with £80 (20% of £100 is £20, leaving £80). In that example, the tax relief is £20.

Is there a limit to tax relief?

There are two limits. You get tax relief on contributions up to your annual earnings. Imagine you earned £20,000 each year, but had £30,000 in savings, and decided one day to put all your savings into a pension. In this situation, you would only earn tax relief on the first £20,000 of your contributions.

The second limit applies to higher earners. You also can also only get tax relief up to your current annual allowance. It's made up of the current year's allowance - which is £40,000 in 2014/15 - while you can also carry forward unused allowances from the previous three tax years.



Money paid by someone else, such as your employer, counts towards those allowances.

You can still save more into a pension but you will only get the tax breaks up to the stated maximums above.
Tax-efficient investments

Like when you invest within an ISA, most of the gains are usually tax-free, so there's no savings tax and no capital gains tax.