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26th September 2017
Many people may say that pensions are complicated, but in most cases the reality is that the arrangement itself is relatively simple and it’s the tax rules and regulations which surround pensions that are complex.
Human nature usually means that if you don’t understand something then you’re unlikely to have much of an interest in it, or you’ll fear it. This rings true for pensions, as few people are genuinely interested in the subject and many glaze over at the mere word, yet every year the Government allocates billions of pounds to reward those who invest in and benefit from pensions, so it makes sense to try to get your share.
If we use the classic carrot and stick scenario; the carrot here is tax relief. This is the Government’s method to encourage people to save money for their retirement by boosting the payments they make into a pension. The more you earn, the more you can save and the more tax relief you can receive, so higher earners benefit the most, but even modest contributions will receive a 20% uplift.
The invested money is protected from both capital gains tax and income tax. Many modern day plans have the additional advantage of being protecting from inheritance tax on death and most arrangements will provide a tax free lump sum. These are tax incentives that most other arrangements don’t benefit from, so are a good reason to save through a pension.
When you reach a specific age (currently 55) the pension bubble can be burst. Historically, this was usually done by using the money to buy a guaranteed regular income stream through the purchase of an annuity and usually alongside a tax free lump sum payment. Another option was to transfer the pot into a drawdown arrangement and decide how much and how often you wanted to take income out once you’d taken a tax free lump sum.
Now the choices are considerably greater as set out below:
When you take money out of the pension, 25% of the payment is usually free from tax and the remaining amount taken is subject to income tax. Tax is payable when benefits are extracted as they aren’t taxed on the way in, plus tax relief is added. Another way of thinking about tax relief is that it’s simply a method of tax deferral.
Most people need to make provision for their retirement beyond what the state provides via the state pension, which many say will not be enough for them to live on when they stop working. Saving via a pension is merely the stick that sacrifices income now, but eventually allows you to pay yourself a salary from the money and tax you saved whilst you were working and earning.
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