How do pensions work? | fool uk

Establishing a pension as soon as possible is an important step in planning for retirement. If you’ve ever wondered how pensions work, read on.

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What is a pension?

A pension is a savings vehicle that you start up during your working life. You make regular contributions until you reach retirement age, at which point you can access it without penalty.

During retirement, you can receive regular income from your pension fund. This allows you to afford the lifestyle you want when you stop working.

Saving for retirement with a pension is more tax efficient than other methods because contributions are tax-free.

When considering how pensions work, you need to understand that there are three main types of pensions in the UK:

  • state pension,
  • work pension
  • personal pension

state pension

This is the government pension that you can claim when you reach state pension age.

The amount of money you receive depends on your Social Security contributions and the number of ‘qualifying’ years of contributions you have made.

For the full state basic pension, you must make 30 years of National Insurance contributions or credits.

The government has been gradually raising the retirement age. In 2016, the system was changed to make it easier to understand.

For more information on how state pensions work, including state pension ages, go to gov.uk website.

work pension

This is a pension established by your employer when you start work. To make it easier for employees to save for retirement, the UK government has changed the way pensions are set up in the workplace.

Employers must automatically enroll all eligible employees in their pension plans. The employee must opt ​​out. More information on workplace pension reforms is available at gov.uk website.

Workplace pensions fall into two basic subcategories, namely defined benefit plans and defined contribution plans.

Defined benefit scheme

A defined benefit plan, or final salary plan, provides guaranteed income for life. Earnings are based on your final salary and years of contributions. During your working life, you and your employer contribute to the plan.

Government and public sector employers offer this type of scheme.

Defined contribution scheme

A defined contribution plan consists of paying into a savings plan managed by a pension provider. Private companies offer this type of scheme.

You, your employer, and the government make the contributions in the form of tax relief. Therefore, the additional income you receive from your employer is a great advantage.

The pension provider invests the money in stocks and shares on your behalf to grow your pot during your working years.

This means that, unlike a defined benefit plan, the amount you receive when you retire is not guaranteed. It depends on the performance of the stock market.

personal pension

This is a defined contribution plan, but you choose the pension provider. This type of pension is used by the self-employed, but you can have one in addition to the work pension.

Any contribution you make will be eligible for tax relief, but there is a limit. In tax year 2020/21, you will receive tax relief on contributions of up to 100% of your annual salary or up to £40,000, whichever is less. You will need to take this into account if you have both a workplace and a personal pension.

Additional information on personal pensions is available at UK government website.

There are two basic types of personal pension, a self-invested personal pension and a shareholder’s pension.

Invested Personal Pension (SIPP)

Unlike a work pension, with a SIPP you can choose the types of investments you make with your pot.

Also, there is a wider range of assets you can invest in. These include UK and overseas listed stocks and shares, unlisted shares, mutual funds and mutual funds.

Interested pension plan

This type of pension must meet specific government requirements that include limited charges and flexible contributions.

If you don’t want to pick and choose your investments, there’s also a default mutual fund you can use.

final thoughts

Retirement planning is a long game and will likely be based on investments, so the sooner you establish a pension, the better. A workplace pension is a good place to start, because you will receive additional income from your employer.

You may consider a personal pension if you are self-employed or have additional income that you want to use for a long-term investment.

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