Saving into a pension, and taking advantage of tax relief, can be extremely rewarding
If you were offered a bank account where for every £80 you put in, £20 would be added, you’d open it in a heartbeat. That proposition exists – it’s your pension, but many of us aren’t taking advantage of it.
Thanks to tax relief, when you pay money into your pension the Government immediately tops it up too – this is free money that'll be missed out on if you don’t save into a pension. The idea is the money you're paying into your pension has been taxed as income when you earned it – the Government simply gives you that tax back when you put money into a pension. It’s an incentive to get people to save for their retirement.
How does it work?
Let’s say you want to put £100 into your pension. When you earned that £100 – assuming you're a basic-rate taxpayer – you had to hand over £20 of it in income tax. So, in order to put £100 into your pension, you're only required to pay in £80, as the Government will add the £20 it took in income tax. If you're a higher or additional rate taxpayer you can claim back the rest of the income tax you paid on pension contributions via your tax return.
The good news doesn’t stop there. Your tax relief is added to your pension savings immediately, so it can grow alongside the rest of your pot. Plus, any growth in your pension investments is tax-free.
That means if you're 30 years of age now and you want to have a £500,000 pension pot when you retire aged 67, you only need to pay in £320 a month. Over the 37-year period the Government will add £35,520 and, assuming a 5% growth rate overall (remember pension investments can go up and down over time), you could have £512,000 when you turn 67. If you have a workplace pension scheme your employer will contribute too, making your final pension pot even bigger.
Tax relief doesn’t just help long-term retirement savings; it can also be a real bonus for anyone approaching retirement age. If you want to do some last minute saving you can still put money into your pension and get an immediate 20% uplift thanks to tax relief. Add that to the fact you can withdraw 25% of your pension savings tax-free once you're over 55, and a pension can be an incredibly tax-efficient savings vehicle for later life.
Don't forget about the limits
Sadly, there are limits on how much tax relief you can enjoy. Each year you can put the equivalent of your annual income, or £40,000, whichever is lower, into your pension and claim tax relief. If you earn less than the Personal Allowance, and therefore pay no income tax, you still get relief on your pension contributions but your annual contribution limit is lower – find out more about tax relief on pension contributions on the Money Advice Service website. Over a lifetime, if your pension pot grows to be worth more than £1,073,100 (2020/21 tax year), then you'll receive no more tax relief and could have to pay a tax charge.
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