While saving into a pension is obviously vital, the sad fact is that a lot can be put off because it all seems to daunting.
The situation is definitely not helped by the fact that the rules around jargon used by the industry can sometimes be complex or outright confusing.
In this article, we’ll run through some key terms alphabetically, including some via Money Advice Service, to help demystify pensions once and for all.
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Additional voluntary contribution (AVC)
Most company pension schemes encourage a certain level of monthly contributions from the employer and employees (usually 3% and 5%, respectively).
If you choose to pay in extra contributions on top of this minimum amount, these are known as additional voluntary contributions.
Annual Allowance
The Annual Allowance, which is currently capped at £40,000, is the amount that can be put into your pension every year (and still receive tax relief).
It’s worth flagging that the Annual Allowance applies across all pension schemes that you are part of.
You should avoid exceeding your annual allowance as you won’t receive tax relief on any contributions over £40,000 and you could receive a tax charge.
Alternatively, you may be able to bring forward unused previous annual allowances to reduce any charges.
Tax relief on pension contributions: how does it work?
Annuity
When you retire, you can use an annuity to get a fixed income for life or for a specific amount of time.
Want more information on annuities? Check out how to buy an annuity.
Automatic enrolment
You’ll be automatically enrolled into a workplace pension scheme if you’re aged between 22 and State Pension age, earn at least £10,000 a year and work in the UK.
Defined Benefit pension
Members of a Defined Benefit scheme are promised a guaranteed pension for life, which is usually based on their final salary and how long they’ve worked for their employer.
These are the ‘gold standard’ of company pension schemes and are expensive to fund, which is why you’re unlikely to be offered one with your current employer unless you work in the public sector.
Defined Contribution scheme
With a Defined Contribution scheme, both you and your employer pay into a pension.
As the pension is usually invested in the stock market, the size of the final pot and the income that it will generate are uncertain, as this will depend on the amount paid in and performance of underlying investments.
Guaranteed Annuity Rate (GAR)
You may be able to get a Guaranteed Annuity Rate from your pension provider, which is likely to offer you a higher level of income compared to elsewhere.
It’s worth making sure you understand the conditions under which the GAR is offered and that it meets your personal needs.
Income drawdown
If you’re not interested in an annuity, you can use income drawdown to keep your pension invested and also dip into it for a regular income.
Of course, there are advantages and disadvantages to using income drawdown, so make sure you do your research beforehand.
Your income is also not guaranteed.
Flexible retirement: your options
Investment fund
When you pay money into your pension, this is invested into one or more investment funds, which can include different assets such as shares or bonds.
Investment funds may have different levels of risk so it’s best to check before you invest.
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Lifetime Allowance
It’s vital that you don’t put over £1,073,100 (the Lifetime Allowance) into your pension as you can get hit with a tax charge when you withdraw your savings.
If you exceed your Lifetime Allowance, you’ll be hit with a huge tax bill of either 25% or 55% of the amount over the limit, depending on if you take the pension as a lump sum or income.
Unfortunately, tax will still have to be paid if you die and leave an untouched pension that exceeds the Lifetime Allowance as your nominated beneficiary will have to foot the bill.
Loyalty bonus
Some pension providers offer a loyalty bonus for customers who stick around, which is usually a saving offered against any charges.
Marginal tax rate
This refers to the marginal Income Tax bands in England, Wales and Northern Ireland – the basic rate (20%), higher rate (40%) and additional rate (45%).
It’s worth noting that income from your pension is added to any other earnings you might have and is taxed depending on which tax band it falls into.
20 ways to pay less tax: cut your Income Tax, Council Tax & Inheritance Tax
Money Purchase Annual Allowance (MPAA)
If you take your entire pension pot as a lump sum or withdraw chunks of money, your MPAA is triggered, which can have a big impact on your pension.
At the time of writing, you can contribute up to £40,000 into your pension every year and receive tax relief, but once you’ve triggered the MPAA, this dramatically falls to £4,000.
Money Purchase Annual Allowance: how to avoid a huge tax bill
Self-invested Personal Pension (SIPP)
A SIPP is a type of personal pension that holds investments until you retire, and you get the same tax relief as other pensions.
One of the advantages of a SIPP is the flexibility – you can pick and choose exactly what you want to invest in to suit your retirement needs.
If you want to find out more about how SIPPs work and details of any fees, check out this guide.
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State Pension
When you reach State Pension age, you’ll get a weekly payment from the UK Government. The amount you receive in State Pension is determined by your National Insurance record.
You can get a State Pension forecast before your retire, check out: How to get a State Pension forecast.
How much the State Pension has increased by in 2020/2021
Tapered Annual Allowance
Your Annual Allowance (mentioned above) could be tapered if your threshold income exceeds £200,000 or your adjusted income goes over £240,000.
For every £2 earned over £240,000, your Annual Allowance is reduced by £1 –and the maximum reduction is £36,000.
Why complex pension tax rules urgently need simplifying
Tax-free lump sum
You can usually withdraw 25% of your pension pot tax-free, known as a ‘tax-free lump sum.’
After you do this, you’ll probably be stuck with a tax bill, which is why planning how to use your savings throughout retirement is vital.
So, there you have it: the basics of pensions in a nutshell.
Remember that, when it comes to pensions, ignorance is rarely bliss, so do your make sure you do your research!
If you want to learn more about retirement planning, read our comprehensive guide to pensions.
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