Ryan O’Leary is a writer and former financial services professional. He writes about personal finance for Wealthsimple and his work has been featured by the New York Stock Exchange. Ryan holds a Bachelor's degree in International Business from University College Cork in Ireland.
What is a private pension?
A private pension, also called a personal pension, is a product that you can use to save money for retirement. Private pensions are usually defined contribution pensions, which means the money you receive at retirement is based on the money that you have paid in and the performance of your investments.
Almost all pension arrangements allow you to take a tax free lump sum within certain limits at retirement; most people avail of this option. You may also be able to take a higher lump sum which is taxable. Different rules apply to the amount of cash you can take out of a pension arrangement depending on the type of arrangement that you have.
What are the advantages of a private pension scheme?
All personal contributions into a private pension scheme receive tax relief. This means deposits will be boosted by 25% by the government.
If you are contributing into an occupational or public services pension scheme, your employer usually takes your pension contributions out of your salary before deducting tax. You then only pay tax on the remainder of your salary. This means that you won’t have paid any tax on your pension contribution.
Meanwhile, if you are paying into a personal pension, you pay income tax on your earnings before you make your pension contribution. However, the pension provider then claims this tax back from the government. So, if you’re a basic rate taxpayer at 20%, for every £80 you pay into your pension, £100 will go into your pension pot. Not bad eh?
If you are a higher rate taxpayer, you can claim the difference through your tax return or by getting in touch with your local tax office. If you are an additional rate taxpayer you will have to claim the difference through your tax return.
The earlier you start investing in a pension, the more you will benefit from compound interest. Basically, when you invest money in a pension, you make a return on it. In the following year, you’ll make a return on both your original sum as well as your first-year return. In the third year, you’ll make a return on your original investment plus two years of returns. This continues right up until retirement age. The gains that you earn on top of previous gains help you build up a considerable pension pot.
What’s more, because you benefit from tax relief on these investments, the savings you make will be higher than if you were to simply put your money in an ISA, for example.
Contributions to a private pension scheme are not usually lifetime transfers of value for the purposes of inheritance tax, and will be immediately excluded from the member's estate. For this reason, pensions are a great way of leaving money to your loved ones while ensuring they can keep as much of that money as possible. However, there are two caveats to this.
One, if the contributions are made while the member is in good health there will be no transfer of value. But if the contributions are made while the member is in ill health, there may be a transfer of value. The underlying principle is that, where the member is likely to survive to take their retirement benefits, then the payments are for their benefit. Therefore they are not transfers of value. It is accepted practice that contributions made more than two years prior to death are not transfers of value.
Two, when a contribution is made to someone else's pension, this would be a lifetime transfer of value. For the inheritance tax they would either be exempt, possibly under the annual exemption or normal expenditure out of income rules, or potentially exempt.
When people get to retirement age, they tend to experience a reduction in income. A well funded pension makes up for this loss of income, enabling one to retire comfortably and perhaps even earlier than otherwise.
This allows pension holders to make the most of retirement and enjoy a better quality of life than would otherwise be possible.
How much tax do you pay on a private pension?
All investments held within a private pension are protected from tax payments. Hence during the life of the pension, no tax is paid. In fact, the taxman will pay you to put money into a private pension, via the tax relief mentioned under the above advantages.
Tax is paid when money is withdrawn from the pension, as per the following.
Can you withdraw money from a private pension?
You can indeed. Withdrawals can be taken from the age of 55, though there are some extenuating circumstances where you can withdraw the money before you turn 55. You can use this to help top up your salary if you are still working. This would enable you to work fewer hours than otherwise necessary or to retire early. This minimum age will rise to 58 in 2028.
You can take up to 25% of the money built up in your pension tax free. This is called the "Tax Free Lump Sum". This lump sum has no effect on your personal allowance.
The remainder of your pension drawings are taxed in the same way as earned income or salary, commonly known as PAYE. These can be taken either on an ad hoc or monthly basis.
The options you have for taking the rest of your pension pot include:
taking all or some of it as cash
buying a product that gives give you a guaranteed income (known as an ‘annuity’) for life
investing it to get a regular, adjustable income (sometimes known as ‘flexi-access drawdown’)
Private pension payments after death
The main rule governing private pensions in death is your age when you pass away and whether you have already started drawing your pension.
If you pass away before the age of 75 and have not started drawing your pension, it can be passed to your beneficiaries and they can access this free of tax. It essentially becomes their pension which they can draw from at their will and free of tax payments. In this scenario, private pension payments after death can either be taken as a lump sum, invested in drawdown or be used to purchase an annuity. Your beneficiaries have two years to claim a death pension, after which point tax may be charged.
If you pass away before the age of 75, but have already started drawing your pension, the way you have chosen to access your savings will determine the action your beneficiaries can take. If you have withdrawn a lump sum and you have remaining cash in your bank account outside your pension, this will be counted as part of your estate. However, if you have opted for drawdown your beneficiaries can access whatever’s left in your pension entirely tax free. This can be via drawdown payments, a lump sum or buying an annuity.
An annuity after death is more complicated. If you have already started receiving income from an annuity before you pass away, this cannot usually be passed to a beneficiary. There are certain types of annuities that are eligible for pension transfer after death, including joint life, value protected and guaranteed term annuities. If you have any of these annuities, your beneficiaries will be able to receive your future payments tax free.
If you pass away after the age of 75, your beneficiaries will need to pay income tax on any pensions you leave behind. This will be charged at their marginal rate of income tax and a large lump sum death benefit, for example, could push them into a higher tax bracket.
Does a private pension affect your state pension?
Contributions into a private pension do not have any impact on your state pension in the modern day. Your state pension is based on your National Insurance contribution history, and is separate from any of your private pensions.
Private pension rules
Annual contribution rules:
In the majority of cases, a maximum of £40,000 can be contributed into a private pension every year. If somebody's annual earnings are less than £40,000, this is their contribution allowance. For example, annual earnings of £25,000 equal a £25,000 allowance. If somebody earns in excess of £150,000, then their annual allowance falls by £1 for every £2 earned over £150,000.
Lifetime Allowance (LTA):
£1.03 million can be saved in a private pension over the course of one’s life. If pension savings exceed this, then tax penalties will be incurred upon withdrawal, on the amount above the LTA.
The first 25% of a private pension can be taken out tax free. The remainder can be accessed as income, or by purchasing an annuity. Annuity rates are poor in the UK at present, so drawdown is proving most popular. Money drawn from a private pension is taxed in the same way as income, using income tax bands and rates.
As mentioned previously, withdrawals can be taken from a private pension from the age of 55. This minimum age will rise to 58 in 2028.
Setting up a private pension
In the UK, setting up a personal pension can take a couple of weeks, as the required information, identity verification and asset allocation must first be completed. With Wealthsimple, this takes no longer than one day. We ensure the client is invested in a suitable portfolio, with ongoing financial advice for a fraction of the cost of the average in the UK (2.56% per annum).
Whether you are just starting a pension or you are well on the way to saving for retirement, we believe Wealthsimple is the best home for your pension. Start a pension now or transfer your existing pension and avail of the kind of personalised, friendly service you might have not thought possible from an automated investing service.