Pensions can be complicated, but simply put, a pension scheme is a type of savings plan which helps you to save money for later in life. These schemes have favourable tax treatment compared to other forms of savings due to the long-term nature of these schemes.
What is a pensions plan?
A pensions plan is a simple pot of money which you and your employer can pay into to save for your retirement.
At the time when you retire, you can draw money from your pension pot or exchange the money with an insurance company for a regular income until death.
There are several types of pension schemes and you are able to use as many plans as you wish, unlike ISAs.
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What types of pension plans are there?
There are many different types of pensions but they tend to be distinguished in two major ways: final salary pensions or defined contribution schemes.
A final salary pension, also known as a defined benefit scheme, are pensions largely funded by employers, though staff may also have to pay into them.
With these pensions, you receive a percentage of your final pre-retirement salary, or when leaving that firm, as an annual income.
A defined contribution scheme, also known as a money purchase pension, is when the money you put into your pension plan is invested and what you have at retirement depends on how those investments perform.
Pension plans tend to be sorted into the following categories:
- Workplace pension schemes
- Trust-based pensions
- Group personal pensions
- Stakeholder pensions
- Self-invested personal pensions.
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How much can you put in a pension?
Technically there is no cap on how much money you can put into your pension.
But there are limits on how much tax relief you can get for topping up your pension.
There are three main tax relief limits you should be aware of: an earnings limit, an annual limit and a lifetime limit.
The earnings limit is the tax relief you receive on contributions up to your annual earnings.
The annual limit is the tax relief up to a certain amount annually (currently £40,000).
The lifetime limit for 2020/2021 is £1,073,000 and it means if your pension is above this amount you face a tax charge.
How much should you contribute to your pension each month?
With the advent of automatic enrolment in 2012 and the legal mandate for this which came in effect from February 1, 2018, more people are steadily putting money into their pension each month.
From April 6, 2019, the minimum employer contribution level increased to three percent.
Under auto-enrolment, total contributions must be at least eight percent, so if the employer only puts in three percent, the employee must pay in five percent.
But experts advise people to contribute more into their pensions if they can afford to do so.
The core advice from most experts regarding your pension is to put in as much as possible as early as possible.
When determining a target figure, you should take the age you start your pension and halve it.
Then put this amount as a percentage of your pre-tax salary into your pension each year until you retire.
So for instance, if you begin contributing at 26, you should contribute 13 percent of your salary, including your employer contribution, for the rest of your working life.
You can use the following pension calculator’s to work how much you need to retire:
- State pension age calculator
- How much will I get from a State Pension?
- Combined state, workplace and DC calculator
- Likely retirement income
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