How do pensions work?

Pensions are one of the most rewarding and tax efficient ways to save for later life. But let’s be honest – they can be baffling at times too.

That’s why we’ve put together this simple and straightforward guide to pensions. We’ve answered the questions you always wanted to know – but weren’t sure where to find the answer.

First though, this guide can give you helpful tips, but it isn’t personal advice. If you’re not sure if something is right for your circumstances, you can find an independent adviser from Unbiased Link opens in a new window. Or you can get guidance from the government’s free Pension Wise service via MoneyHelper Link opens in a new window.

What is a pension?

So, what exactly is a pension? In its simplest form, it’s a pot you pay into as a way of saving for later life.

The money you pay in is usually ‘locked away’ until you’re 55 (rising to 57 in 2028). This is to make sure you have enough money saved up to last you through your later life.

And the good news is that you don’t have to save up on your own. The government and your employer (if you’ve got one) can help out too.

How do pensions work?

It may surprise you to know that with a pension (whether it’s a workplace pension or a personal pension), your money is invested in the stock market. That means most people in the UK who are employed are actually investors!

In a way, pensions are pretty cool, because they bust the myth that you need to be super wealthy or know what you’re doing to be an investor.

Why are pensions invested in the stock market?

When you save money as cash, inflation (which is set by the Bank of England at a target of 2%) eats away at it. Meaning the value of your money could decrease in real terms. So, you won’t be able to buy as much with the same amount in the future as you can now. Pensions are invested in the stock market so that they can benefit from growth that has the potential to beat inflation, but it’s not a guarantee.

What is tax relief?

Paying money into a pension also has an extra benefit.

When you put money in a pension, the government gives you tax relief on your contributions – usually up to a maximum of £60,000 for each tax year. That means some of the tax you may have paid to the government through your earnings goes to your pension instead.

The tax relief you usually get from the government is 20%, so for example for every £80 you put into your pension - the government puts in an extra £20. You can claim even more if you’re a higher rate taxpayer. For free. Read more here Link opens in a new window.

Where can you get a pension?

If you’re an employee, you may be enrolled automatically into your company’s pension scheme. This depends on your age and earnings.

This type of pension scheme is known as a ‘workplace pension’. You pay into the pension and so does your employer. Sometimes, the more you contribute to your pension, the more your employer also contributes. Plus, you get the government tax top up too.

If you’re self-employed, not working, or you want to have multiple pension pots for later life, you can take out a pension plan or open a pension account directly with a pension provider.

You can do this online with most providers and pay in whenever it suits you. You can make regular payments every month, make one-off payments whenever you want – or do a mixture of the two.

There are different kinds of pensions, but the most common personal pension is called a SIPP (Self Invested Personal Pension).

How much should you pay in?

How much you pay into your pension depends on your personal circumstances and the type of life you want to have in the future.

Pensions were designed to provide you with an income once you stop working. But we’re living longer, and our pensions need to stretch a lot farther than they used to.

Some experts say you should try and put away half your age as a percentage of your salary. So, if you’re 30, you should aim to pay 15% of your pre-tax salary into your pension. If you can’t afford to do that, don’t worry. Just put away what you can to start with. Even small amounts add up over time. And the sooner you start, the more you’ll have in your pot when you’re ready to retire.

What happens when you’re ready to access your pension pot?

There’s a few different options available to you once you decide to access your pension.

For example you can;

• Take your pension in full as one lump sum
• Take your pension as multiple lump sums
• Take a 25% tax free lump sum and keep the other 75% invested
• Draw an income from your pension in time frames that suit you (monthly, quarterly, annually…)
• Purchase a guaranteed income for life with your pension. This is called an annuity.

And you don’t have to pick one option over another. You can mix and match and decide which options work for you. But it’s worth bearing in mind that whatever option you choose, you’ll likely have income tax to pay depending on your circumstances.

We’ve put together an in-depth guide on your pension options which you can read here.

And that’s it. That’s pensions for you.

If you’re still feeling confused, don’t worry. Pensions can be hard to get your head around.

You can get some free help from the government-funded service, Pension Wise from MoneyHelper Link opens in a new window. Find out more at moneyhelper.org or give them a ring on 0800 138 3944.

The government’s guidance guarantee means you’ll always get free and impartial help so you understand your choices.