But the most effective retirement strategy uses a combination of approaches. Other investment options, such as ISAs, can make your retirement plan more flexible than using pensions alone.
A pension is an investment vehicle designed to help you save for retirement.
You may have a Defined Benefit pension, which provides a guaranteed income depending on your salary and years of service. In this case, your defined benefit pension could form the baseline of your retirement strategy, although you may wish to supplement this with additional savings.
This guide is mainly concerned with Money Purchase pensions, which allow you to build up a pot of money to fund your retirement.
A Money Purchase pension works as follows:
- You can personally contribute up to £3,600 per year into a pension, or the equivalent of your gross salary if this is higher.
- Your gross contribution is made up of your net contribution, plus 20% tax relief. So a contribution of £3,600 would be made up of £2,880 paid by you, and £720 paid by HMRC.
- Higher and additional rate taxpayers can claim further relief through their tax returns.
- Your employer can also contribute to your pension.
- Personal and employer contributions are subject to an overall annual allowance of £40,000 per year. This can be carried forward by up to three tax years if you are a member of a pension scheme and have not used your full allowance.
- Your annual allowance could be reduced if you earn above £240,000 or if you have taken benefits from a Money Purchase pension.
- Your total pension savings (including any Defined Benefit schemes) will be measured against the Lifetime Allowance (currently £1,073,100) with tax of up to 55% payable on the excess.
- Pension funds grow free of tax on any income or gains generated within the fund.
- At retirement, you can withdraw a 25% tax-free lump sum.
- The remainder of your pot can be withdrawn as you wish, and is taxed at your marginal rate.
- Pensions are outside your estate for Inheritance Tax purposes, and can be paid out free of tax if you die before age 75. After age 75, the fund can be withdrawn by your beneficiaries, taxed at their personal rates.
- Pensions are extremely tax efficient providing you remain within allowances.
- Your pension cannot be accessed until age 55 (although this is rising to 57, and will subsequently remain ten years under State Pension age), which removes the temptation to take early withdrawals.
- If you are working, your employer is required to contribute to your pension if you do. If you have your own company, your pension contributions are an allowable expense.
- The minimum pension age means that you will need to make other plans if you would like to retire early.
- Annual and Lifetime Allowances can make pension planning complicated, particularly for high earners.
- Your pension income will be taxed. If you need to increase your pension income or withdraw a lump sum, this may push you into a higher tax bracket.
Individual Savings Accounts (ISAs)
An ISA is a savings or investment account that can be used for any purpose, including retirement planning.
- You can contribute up to £20,000 per year.
- You can invest in cash, stocks and shares, or both.
- Investment income and gains are tax-free.
- You can access your money without tax or penalty (unless imposed by the ISA contract).
- If you withdraw money, you can replace it in the same tax year without using up any of your ISA allowance.
- You can make withdrawals at any time, regardless of age.
- There are no tax implications on accessing your money.
- Other than the contribution limit, there are no complicated restrictions on how much you can pay in or how much you accumulate. Higher earners have the same ISA allowance as anyone else.
- There is no tax relief on contributions.
- As you can access the money whenever you wish, it can be tempting to dip into the fund earlier than planned.
- Higher earners may find the ISA allowance limiting, particularly if their pension allowances are also capped. Other investment options may need to be considered in addition.
- ISAs are included within your estate for Inheritance Tax purposes.