A pension is a fund that helps you save up for retirement. You make contributions to the fund as you earn your wages, and your employer also pays in, too. When you retire, you can then draw money from your pension fund, or exchange the fund with an insurance company for a regular income (known as an annuity), which covers you financially for the rest of your life. As of 2015, pension funds are becoming more flexible and savers are able to have access to their pension funds more easily, withdrawing as much cash as they want to, when they want to.

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How does a pension work?

A pension works by you saving a small portion of your current salary into a fund that you can use in later life. It is important to budget how much you can afford to put aside for your pension. A main bonus of a pension plan is that it offers tax relief on the money you put in. Generally, you receive tax back on everything you’ve saved. Whether you pay money into your pension fund yourself, or your employer adds contributions of their own, you automatically receive a 20% tax refund back from the Government. Those on higher tax rates can claim an extra 20% on top of this, while those who pay the top rate of tax can claim back 25%. If you have a workplace pension, you don’t need to reclaim tax if your employer deducts a smaller amount of tax from your salary. Visit the HMRC guidelines on how to reclaim pension tax.

Bear in mind that pension tax relief doesn’t mean that you will receive 20% back of total funds you have contributed, it simply means that you get a 20% tax relief on your pre-tax earnings. For instance, if a person on the standard rate of tax (20%), invests £80 of their salary in a pension, the tax they have to pay from their earnings means that they would have originally put in £100 pre-tax. There is therefore a £20 relief (20% of the £100).

Many companies offering workplace pensions to employees choose to use third-party pension companies to hold pension funds. You can however speak to the third-party company and make decisions on your pension and how you’d like to manage it. If you decide to start your own pension, you can choose the company you hold it with.

How much can I put into a pension?

You can put as much money as you like into a pension, but there are limits to the amount of tax relief you can receive. You can receive tax relief on contributions you make up to your annual salary. For example, if you earned £20,000 per year, but had more than this (£40,000) in savings, because you only earn £20,000, you only get tax relief on the first £20,000 of your contributions. Anything over this £20,000 you’ll need to pay tax on.

Types of pension

There are three main types of pension available – these are a State pension, defined benefit (DB) pension and a defined contribution (DC) pension.

State pension

The state pension is paid by the government and increases by at least the annual rate of inflation. The government makes contributions towards this pot of money to help people in retirement. Most citizens have a State pension. National Insurance contributions you make help pay for your State pension. As of April 2016, the State pension is £168.60 per week. To be eligible for a full State pension, you need to have 35 years of National Insurance payments on record.

Defined Benefit (DB) pension

A defined benefit pension is for those working in very large companies or in the public sector. Pensions depend on how many years of service an individual has accrued, thereby increasing every year. Some people with defined benefit pensions have ‘final salary schemes’ whereby their pension is based on their pay when they leave work and retire.

Defined contribution pension (DC) pension

A defined contribution pension is a cash fund that you can draw an income from once you retire or work less. To be eligible, you must be 55 or over. This type of pension enables you to withdraw at least 25% of your pension fund tax-free. Your overall pension pot depends on how much you and your employer contribute, what is invested and how, and how much you pay in charges. Defined contribution pensions cover personal, workplace and stakeholder pension plans.

Auto-enrolment and pensions

Employers must now enrol all employees over 22 earning at least £10,000 per year into a pension scheme in accordance with new legislation. As of 6 April 2019, the minimum an employer can contribute to a pension scheme is 3%. This means that the employee has to contribute 5%, as total contributions must equal 8%.

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What happens to my pension when I retire?

Keep in mind that once you have put money into a pension fund, it cannot be taken out whenever you like. You will have to wait until you are at least 55 years old, when you can take 25% of it without paying tax. If you take more than this, you will be charged tax at normal rates (20%) The rest will act as a fund that you can take a drawdown from for the rest of your life.