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7 great reasons to invest in pensions
Monday 10th May, 2021
Pensions can seem complicated, but understanding their advantages and how they work can save you tax now, as well as helping you build your retirement savings. So here are 7 great benefits of using a pension.
I come across several objections when suggesting pensions to my clients. Which, although valid, do not consider the full story.
Some client objections include:
- I don’t want my money locked up until age 55
- They are too complicated
- They never perform well
- Why would I want one? Annuity rates are terrible!
- Aren’t they very expensive?
These are all valid concerns, but as I say, do not consider the full story. Below are some of the reasons you should be using a pension:
1. Tax relief
You are able to claim tax relief on your contributions. If you contribute personally to your pension, the pension provider will claim back 20% tax relief from HMRC. This means that if you pay £100 into your pension from your net pay, £25 will be added to it. If you are a higher rate taxpayer, you can claim a further 20% tax relief through your tax return or having your tax code adjusted.
Alternatively, if your employer pays contributions into your pension on your behalf, the payments are paid out of your pre-tax income. This means that you get immediate tax relief on this payment, as you do not have to pay tax or National Insurance on the funds being paid into your pension.
If I were to tell you about an investment where you could get an immediate 20% - 40% return, you would probably bite my hand off. However, with pensions there remains a huge reluctance to take advantage of the reliefs available.
2. Tax free growth
Your funds grow in a tax-free environment. This means that your returns are not taxed on an arising basis. In other words, the money you would normally pay out in tax, remains invested and generates additional returns for you. This is known as gross roll up and can result in a substantial increase in your overall returns over the lengthy time that your pension is likely to be invested for.
There are exceptions to the tax-free rule. For example, you may have to pay withholding taxes on some of the dividends produced by shares or funds held on stock markets in other countries. However, this is generally the exception to the rule and won’t make a massive difference to your returns. Therefore, I will continue to refer to the pension environment as tax free.
3. 25% Tax Free Lump Sum
Regardless of the tax-free pension environment, the fact remains that most of your withdrawals from the pension will be treated as income and taxed accordingly. While this does detract slightly from the overall tax efficiency of the vehicle, it is important to remember that you can still take up to 25% of the accumulated pension tax free when you retire. This is a very useful relief and if used correctly, can hugely increase the overall tax efficiency of the pension.
For those looking to pay off their mortgage at retirement, the 25% lump sum could be perfect for achieving this.
4. IHT exempt
For most pensions, their value is outside of the estate for IHT purposes.
In addition to this, (since 2015) you can now leave your pension to anybody you wish, without suffering harsh penalties that eat up 55% of the pension value. This means that what remains of your pension upon death can form a useful legacy to your loved ones. In the correct circumstances, the pension could transfer to them free from IHT, Income Tax or Capital Gains Tax. There may be a Lifetime Allowance charge, depending on the value of the pension, however, for most people this won’t be the case.
When one considers that a pension is often an individual’s most valuable asset, the ability to pass it on to your loved ones with little tax liability can be a real advantage.
5. Greater flexibility
It is true that annuity rates are terrible. However, due to the pension freedoms introduced, it is no longer necessary to purchase an annuity. You can now leave the funds invested in the pension and simply drawdown from the pension as and when you need it using either Flexi-Access Drawdown or Uncrystallised Fund Pension Lump Sums.
This means that (from age 55) you can draw out what you need, increasing or decreasing the income as your tax and spending requirements demand. You are also able to take your tax-free lump sum in increments (many believe it must all be taken at once). It is also possible to blend tax free and taxable income from the pension to make it more tax efficient and reduce how much needs to be withdrawn each year.
6. A great way to take money out of your business
Many business owners work very hard to achieve success with their business. However, a problem sometimes arises when cash starts to build up in the business accounts. In these circumstances, the question arises as to what the best method is to take the cash from the business? For any business owner, this is a great problem to have.
It is often inefficient to take cash as earnings or a bonus, as this is subject to income tax as high as 45%, while also creating National Insurance costs for both the business and the recipient. Dividends are potentially more tax efficient, but the profits will first be subject to Corporation Tax for the business and then dividend tax of up to 38.1%, depending on how much is withdrawn.
It is possible to avoid some of these problems by paying some of the accumulated cash into pensions. This can be up to each owner’s available annual allowance, which could be as high as £160,000, depending on circumstances. The payment can be made into the business owners’ pension free from tax and National Insurance and under the correct circumstances can be treated as a business expense by the company that can be offset against Corporation Tax.
7. Pensions don’t perform well
This does not highlight an advantage of a pension but is aimed at addressing a fundamental misunderstanding about pensions.
When we are talking about pensions and performance, we are inevitably looking at Defined Contribution Pensions and not Final Salary Pensions. In this case it is important to recognise that the performance of the pension is dictated by the investments held within it. This can consist of individual shares, corporate bonds, gilts, various funds, commercial property, funds investing in commodities and so much more.
If poor investment choices are made, or investments are never reviewed, then there is a strong possibility that performance will reflect that, for it is a universal truth that what you get out is generally determined by the effort you put in.
However, it is completely erroneous to suggest that pensions, as a class of investment wrapper, generate poor returns.
For example, one of my clients held a commercial property within her pension that she leased out to a fast-food chain. Her problem wasn’t poor returns, but rather that the rental income being paid each month was so substantial that it was pushing her rapidly towards her protected Lifetime Allowance and a potentially substantial future tax liability. There was little she could do to address this and, if we’re honest, it wasn’t the worst problem in the world to have. But it does illustrate that pensions can, and often do, perform really well.
The points I have listed above are just a few of the benefits of investing into a pension. There may be many more, depending on your circumstances and what you are trying to achieve. In our Guide to Pensions, we will look at some of the technical aspects of pensions and clarify how they work.
Please click the link to see our video on 7 Great Reason to Invest in Pensions
If you would like further information on pensions, please look through our other articles. Another great source of pension information is Pension Wise or Which?