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What are pensions?

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Written by Dom James, Financial Content Writer

19 June 2020

You can use a pension as an income during your retirement, but there are several types and many rely on how much money you put into them. Here is how they work.

Pensions are long term investments. You may get back less than you originally paid in because your capital is not guaranteed and charges may apply.

What is a pension?

It is a type of income you get when you retire. The amount you get depends on how much you contributed to your pension fund during your working life.

The three main types of pension are:

  1. Employer's pension

  2. State pension

  3. Self Invested Personal Pension (SIPP)

Employer's pension

This is also known as a workplace pension and usually comes in two schemes:

  • Defined contribution: You and your employer contribute when you get paid which determines how much of an income you get when you retire.

  • Defined benefit: Your employer guarantees your pension amount based on your length of service and salary.

Here is more information on workplace pensions

State pension

If you are a UK resident and have made National Insurance contributions throughout your life you should qualify for a State Pension.

There are two types of State Pension, and the one you get depends on when you retire:

  • New State Pension: Retire after 6th April 2016

  • Basic State Pension: Retire before 6th April 2016

Here is more information on the State Pension

Self Invested Personal Pension (SIPP)

You can open and manage a Self Invested Personal Pension without any help from an independent financial adviser or pension company representative.

Make sure you understand the risks of investing in a SIPP before you invest, or speak to an independent financial adviser to discuss your options.

Here is more information on SIPPs

Why pay into a pension?

Paying into a pension is generally a good idea. Once you retire, or turn 55 and perhaps start working less, a pensions allows you to receive an income on which to live.

While there are many ways to save and invest for your retirement, a pension provides great benefits when it comes to putting money aside for you golden years.

  • Tax relief. Not only are pensions contributions tax free, the government adds 25% to any contributions you put in up to a certain limit; and, if you’re a higher or additional rate taxpayer, you can claim even more via your tax return form.

  • Workplace pensions. A workplace pension legally requires employers to contribute to a pension on your behalf. Not only do you receive contributions from the government in the form of tax relief, you also receive contributions from your employer. Ask your employer if you’re not sure how much they contribute to your workplace pension.

Pension investments are free from income tax and capital gains tax, so you won't pay tax on any dividends from shares and you won’t pay capital gains tax on any profits made from the investments within your pension pots. However, there are income tax implications when you start to withdraw from your pension.

How do you receive money from a pension?

Typically, pensions set an age from which you can start withdrawing from your pension. This is usually somewhere between 55 and 65.

When the time comes to start taking money from your pension, you’ll need to decide how you want to do this.

  • If you’ve got an individual pension or a defined contribution pension, you can take up to 25% of its value as a tax-free lump sum. You’ll usually pay tax on the rest, which you can either take as cash, use it to buy a guaranteed income for the rest of your life, leave invested and make regular or one-off withdrawals over time.

  • With a defined benefits pension, you may be able to take some of its value as a tax-free lump sum, but this will depend on the rules of your scheme. The rest of the money will be paid to you as a guaranteed income for the rest of your life

Pension FAQs

As much as you want, but only a proportion of your contributions each year will be tax free. Find out more information on pension tax here.

It depends on your pension type, but you could face tax charges if you try to withdraw earlier than your retirement age. Find out more here.

Yes, you can monitor the performance of most pensions whenever you like. Find out how to manage your pension here.

Some workplace pensions and SIPPs can be transferred, but make sure you consider any charges for doing so. This guide explains more

Yes, but only if you are an eligible employee and work for an employer who has reached their auto enrolment date. Find out more information here.

You can help ensure you have the retirement you want by finding the best personal pension plan to make your money work as hard as it can.

Compare pensions

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