What is a pension – and why do we need one?
The original meaning of ‘pension’ was a gift, a payment from a benefactor to pay your lodgings and see you through your university education.
Well, things have changed, and these days we have to earn our pension with the sweat of our brow, over forty years of toil, sacrifice, and bad coffee, in the workplaces of the nation.
These days, a pension is a long-term investment which provides us with an income in later life. It may be intended to fund our leisure lifestyle once we finish work, but the payments from our pension scheme can also kick in before then, supplementing to our working income as we approach retirement.
Pensions come in various types, and good pension advice is necessary to decide which is right for you. However, as long-term savings vehicles, all have one great advantage in common: the contributions to a pension plan attract pension tax relief at your marginal rate.
This means that a 20% taxpayer will have his pensions contributions topped up by 20% by the Government, and a 40% taxpayer will receive tax relief at 40%. This tax advantage makes a pension plan the deal to steal, when saving for old age.
Let us tell you how tax relief on pension contributions will boost your savings. Click here for Pensions Advice or call 0800 678 5929
Pensions plans can come as a company pension or a personal or private pension plan. No matter which, the tax advantage of pensions saving works like this.
For those earning £44,875 or less per year, the marginal tax rate is 20%. Those earning more than will pay income tax at the higher tax rate of 40%. Pension contributions tax relief is paid to both from tax they have already paid, and at the same percentage as the tax they pay.
This means that for the basic tax payer, for every £100 paid into the pension, 20% will be made up of pension tax relief. In other words, he pays only £80 of that, and the remaining 20% or £20 in the £100 is pension tax relief. For the higher taxpayer, 40% of the total pension contribution of £100, in other words £40, will be pensions tax relief. This means that the higher rate taxpayer only had to pay in £60, in order to achieve a full £100 contribution to their pension. Only £20 of the £40 will be paid into the pension, however, and the other £20 must be reclaimed when submitting his tax return. It is taken as cash, and can be spent as the saver wishes – there is no obligation to pay it into the pension.
A pension is a tax-free vessel in which we store our pension contributions, but they do not simply lie in the pension fund until we retire. Pension savings in pension schemes are invested, mainly in the stock markets, and growth in their value is also paid into the pension fund, so that the value of the pension pot compounds over the years. In other words, funds in pension schemes accrue interest, and in the following year, interest on the interest, and so on. In the long term, the compound growth in pension schemes can be very impressive, particularly given the length of time they are invested.
The difference between stocks investments and a cash deposit in a bank account gives an idea of the power of a pensions scheme to grow your money. An investment of £100 made in 1945 and growing in step with the Retail Prices Index would have grown to £2,764 by 2006. The same £100 invested in stocks and shares, as measured by the Barclays Equity Index, would have grown to £125,000 in the same time!
It is this powerful combination of a tax-relief boost on day one, combined with long-term exposure to stock market growth, that makes pension schemes such a perfect choice for investing for retirement.
