Understanding pensions is not easy. There is a lot of jargon, much which goes over people’s heads. In this article, we’ll cut through some of the complicated language and explain what it means, to enable you to gain a better understanding of private pension rules.
What is a private pension?
Where your state pension is organised by the UK government, a private pension is one that you, yourself set up. It can also be set up by your employer – in this case, it’s referred to as a workplace pension. When you compare the two, the pension lump rules are quite different.
Whereas with a private pension you can withdraw up to 25% of your pot tax-free, there is no tax-free allowance on your state pension. Usually, retirees withdraw their pensions every four weeks. However, you can defer payments for 12 months and, instead, take 12 months’ worth of cash retrospectively.
How private pensions work
Private pensions and workplace pensions work in a similar fashion. The big difference is that your employer sets up your workplace scheme, whereas it is down to the individual to set up a private pension.
The money you pay into a personal pension scheme is ordinarily used (by you or your wealth manager) to purchase various assets that can include cash, bonds, property and shares. The choice of which assets you select reflects how much risk you are comfortable taking and how far from retirement you are.
When you get to 55 years of age (this pension rule changes in 2028 to 57), you can take your personal pension as a lump sum or as a series of withdrawals, or you can use it to purchase an annuity to give you an ongoing, guaranteed income throughout your retirement.
Types of private pension
There are two types of private (sometimes referred to as “personal”) pensions. They are the ‘defined contribution pension’ and the ‘defined benefit pension’. The first gives you a pension pot based on how much you pay in, and the second is based on the size of your salary and how long you have been working for your employer. This second type of pension is often in the form of a workplace pension.
How the pension lump sum rules differ
Pension withdrawal rules are different between defined contribution and benefit pensions. The defined contribution lump sum allowance is straightforward. You can take out up to a maximum 25% lump sum of your pension tax-free when you hit 55.
This is a little more complicated with a defined benefits scheme. The size of the tax-free lump sum you can withdraw is calculated by something referred to as the ‘commutation factor’. Basically, this factor relates to how much of your final pot you are sacrificing for up-front cash. Generally speaking, the higher the commutation rate, the better it is for you.
Private pension drawdown rules
Drawdown rules govern how much of your pension pot you can withdraw. You might elect to withdraw your 25% tax-free element and leave the balance invested, or you might prefer to drawdown lump sums as and when you need them. Alternatively, you might decide to withdraw the entire pot in one fell swoop. However, it wasn’t always this way.
In 2015, pension drawdown rule changes were brought in to allow people improved access to their pension savings. The amount of income tax was also changed from the previous 55% to a marginal rate.
Other changes to private pension fund drawdown rules included not being forced to buy an annuity when you reach the age of 75 and being able to avail yourself of drawdown schemes that, up until then, only wealthier pensioners could enjoy.
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Changed to capped withdrawal pensions
Another of the changes made in 2015 to private pension rules was to stop offering capped withdrawal pensions to new investors. However, people with current capped schemes can continue to enjoy their benefits.
Capped withdrawals differ from drawdowns because they are capped, whereas drawdowns are not.
Personal pension contribution rules
The contribution limit, according to current private pension rules, is all of your income up to £40,000 per annum. Anything over and above this ceiling will not qualify for tax relief. SIPP pension rules share the same cap on contributions.
In April 2016, a tapered allowance was introduced with regard to high earners – basically anyone earning more than £200,000 per annum.
UK pension tax rules could be changing
There is some speculation that private pension scheme rules could be changing. It is a result of the costs incurred because of the COVID-19 pandemic.
Possible changes include reducing the pension lifetime allowance from an estimated £1,073,000 to £900,000 or £800,000 – in effect bringing down the level at which additional tax charges might be made.
Another change could be everyone getting approximately 30% tax relief as opposed to 40% enjoyed by higher rate taxpayers. There is also talk of introducing a tax increase on contributions made by employers.
The importance of paying into a personal pension
The state pension is not enough to support many people in their retirement, so it is recommended that you take out a private pension to keep you living the lifestyle to which you have become accustomed.
While it may not be comfortable to start pension contributions at an early age, it is desirable. There is not only a tax benefit, but the contributions you make have a chance to grow and earn compound interest to give you the sort of final pension pot on which you can live in relative comfort.
The rule of thumb pension contribution recommendation goes like this:
Note the age at which you begin making pension contributions and halve it. Then use this figure as a percentage of how much of your salary before tax you need to pay into your pension every year until you reach retirement age.
The figure may scare you, but the later you start making contributions, the higher they will need to be.