Put simply, a pension is just a way of deferring the use of current earnings, for use in the future. All the other aspects of tax relief, legislation and products are merely a way of achieving this. Everyone has the right to defer at least some of their income in this way.
Pensions come in different forms, such as state and salary related schemes. Here we will focus on the most common – technically called Defined Contribution schemes – whereby amounts are saved and invested until retirement, when they can be drawn. These are the schemes most people will have the option to save through.
You will get your state pension based on your National Insurance record and it’s very rare that someone offered the chance to join their employer’s salary related scheme would not want to do so.
There are a lot of misconceptions about what a pension is and how it is invested. Many see pensions as a black hole, into which money disappears, with no transparency or visibility. Whilst this is not too far off for some old schemes, modern pensions can be completely open, transparent and flexible.
They can be viewed alongside any other form of saving. The process of income deferral and tax relief just adds a tax ‘wrapper’ – you can still buy and sell investments with complete transparency and control. When deciding how to save, a pension can be compared to direct investments or another form of tax vehicle, such as an ISA.
Should I save through a pension?
Most people now have some form of pension; government rules have seen millions join workplace schemes over the last few years. Personal circumstances will dictate the exact decision on saving through a pension, but it will make sense for most people.
The key issue, particularly for those in their 30s/40s, is that they won’t be able to access their pension until their late 50’s (1). So, the question is whether you can put money away, without being able to access it.
For the purpose of retirement planning, where you are intending to put money away for the long term, pensions are very effective due to the generous tax reliefs afforded. Usually far more so than other savings vehicles.
If you are an employee, it is highly likely it will make sense to join your employer’s scheme, as they will be partially funding it – opting out would be akin to turning down additional pay.
Remuneration Planning / Profit Extraction
For business owners pensions can offer a very efficient form of profit extraction. Contributions are tax free personally and are an allowable business expense (2) making them completely tax free at the point of contribution. Pension funds then grow free of UK income and capital gains taxes.
This can be in stark contrast to the high effective rates of extracting profits through dividends (corporation tax and income tax) or salary/bonus (employer and employee National Insurance Contributions plus income tax) for high earners.
Ultimately pension income will be taxable when you draw benefits. However, under currently rules, 25% can be taken as a tax-free pension commencement lump sum, meaning a quarter of accumulated funds will have been drawn from the business completely tax free.
The remaining 75% will be subject to income tax, however pension income is usually taken when earned income has reduced/ceased, resulting in lower rates of tax (than were initially avoided by the contribution).
Estate Planning
Under current rules, pensions can also offer significant benefits in terms of estate planning. Crucially, pensions are free of Inheritance Tax (3).
Furthermore, in the event of death pre-age 75, benefits can be paid to your selected beneficiaries as a 100% tax free lump sum (4). In this circumstance, gross profits could flow from a business to the pension and then onto the next generation without any tax being incurred. It is also possible to pay these death benefits tax-free to a trust for the benefit of your family, avoiding the funds passing into anyone’s estate.
After age 75, the amounts can be taken as a taxable income by your beneficiaries, subject to tax at their marginal rate. Here pension benefits can be left intact to fund your children or grandchildren’s retirements.
Financial planning in a bucket
Pensions are just one tool – albeit a very useful one – that should be used in your financial plan.
In describing financial planning, we often use the analogy of a bucket of water, where the water represents your liquid assets. You have water pouring into the top of the bucket from your income, but also a tap at the bottom, with water flowing out for your expenditure.
You always need to have enough in the bucket to keep that tap flowing at the rate you need/chose – you don’t want it to ever run-out. But you also don’t want it to over-flow – if this happens you haven’t made the most of your assets; spent or given away everything you could have.
You need liquid assets available throughout your life. If you can put money aside i.e. you have enough money in your bucket before retirement, saving into pensions can then help top up the bucket and fund expenditure in later life.
Their advantageous tax treatment can help maximise resources and stop the bucket running out in later life. Thanks to the treatment of death benefits, they can also reduce the problem of bucket overflowing.
If you have any questions about pensions or need assistance with any aspect of planning, please do get in touch and we will be glad to help.
(1) You can currently access pension benefits from age 55. In 2028 this will increase to age 57 and will rise with the state pension age (remaining 10 years below).
(2) For an employer pension contribution to be tax relievable it must be justifiable as part of an employee’s remuneration strategy. The decision on whether it is an allowable expense rests with the local inspector of taxes. This is not usually a problem for business owner directors.
(3) There are circumstances where this may not be the case, but they are rare. If you are in any doubt, please speak to a professional adviser.
(4) Death benefits must be paid within 2 years of death.