Take advantage of pension tax breaks with a Sipp

Workie sitting on a park bench © DWP
Saving for retirement isn’t scary – the workplace pension is here to help

Isas are a good choice for most types of saving, but your workplace pension and/or a self-invested personal pension can be a better option for your retirement.

A pension is more restrictive than an Isa – you can’t get at your money until you reach a minimum age (55 at present for most schemes, rising to 57 in 2028) and you will have to pay income tax when you take it out. These disadvantages are offset for many investors by generous up-front tax relief on your contributions.

When you pay money into your pension, the government refunds any income tax you have paid on that money. So, if you pay in £800, the government assumes you paid basic-rate income tax on that money at 20% and refunds that straight into your pension, meaning they add a further £200. If you are a higher-rate or additional-rate taxpayer, you get 20% tax relief back and can claim the rest back via your tax return. That’s a big boost to your savings.

Profit from your employer

If you pay into a pension through your workplace, you will also benefit from contributions made on your behalf by your employer. The minimum that your employer has to contribute is 1% of your salary, but this is rising to 2% from April 2018 and 3% in April 2019. Your minimum contribution to a workplace pension will go up from 1% to 3% and 5% at the same times – so in a year’s time, the total will be 8%.

While this is a good starting point, it will not be enough to fund an adequate retirement, so you will need to set aside more. It may be worth increasing your contributions to your workplace pension – many employers will make additional contributions if you pay in more. However, if they don’t – or if you simply want more flexibility to manage your own investments  – you can pay into a self-invested personal pension (Sipp) alongside your workplace pension.

There is a limit on how much you can pay into a pension each year and still get tax relief, known as the annual allowance. This applies across all of your pensions schemes in total. This is equal to your relevant UK earnings (for most people, essentially your income from work), capped at a maximum of £40,000 per year (this is the gross figure – ie, including the tax relief you’ll get in your contributions). Unlike Isas, unused allowances can be rolled forwards for three years if you have sufficient earnings to use them.

If you earn more than £150,000 a year then your annual allowance is tapered away. You lose £1 of your allowance for every £2 you earn over £150,000 up to a maximum cut of £30,000. So, anyone earning over £210,000 a year can only put £10,000 a year into their pension. If you don’t have any earnings, you can still contribute up to £2,880, to which the government will add tax relief at 20% (even though you didn’t pay tax), giving you a total contribution of up to £3,600.

Taxed when taking your pension

When you reach the age at which you can begin drawing your pension, you can take 25% of your pot as a tax-free lump sum. This doesn’t have to be all in one go – you can spread it out over a number of years. The rest of your pension can be used to buy an annuity to get a guaranteed income, left invested and drawn down over time or a combination of both options. Either way, it will be taxed as income at your marginal rate in the usual way as you receive it.

A second cap called the lifetime allowance limits how large your pension savings can grow. If you exceed this, you will pay a 25% additional charge if you take the excess as income or 55% as a lump sum. The lifetime allowance is currently £1m, rising to £1.03m in April. If your pension passed £1m before April 2016, you may be entitled to a higher limit – check with HM Revenue & Customs.

Our pick for a pension

Best for… small and simple

Cavendish Online and Fidelity is good for low-cost, fund-based pensions. There’s a custody fee of 0.25% a year, reducing to 0.2% on portfolios over £200,000. This is cost-effective for small pensions as there’s no minimum charge and no dealing fees.

Best for… large and simple

Flat-fee platforms that charge a fixed annual fee can be good value for bigger portfolios. Share Centre charges £12+VAT per month plus 1% to buy or sell a fund or share (with a minimum of £7.5). Alliance Trust Savings is also competitive for large portfolios.

Best for… shares or mixed portfolios

AJ Bell Youinvest, Charles Stanley and Hargreaves Lansdown offer a wider range of investments. They charge an annual custody fee, which is capped for shares, investment trusts and ETFs.

Best for… property and other assets

If you want to hold exotic assets such as commercial property, look at Sipp, Carey Pension Trustees or Corporate & Professional. AJ Bell’s Platinum Sipp also lets you invest in property.

Best for… a Lifetime Isa

The lifetime Isa is a hybrid of a pension and an Isa. AJ Bell and Hargreaves Lansdown are the main options.