Everything you need to know about pensions

Pensions' is the most boring word in the English language, hands down.

Just writing the word makes me want to switch my computer off and do something - anything - else.

The name conjures up images of mis-selling scandals, budget deficits, dodgy small print, and desperately scrimping to get enough money for a cup of tea in your twilight years.

I know I'm not the only one to feel this way. The fact that we've all become so averse to what is ultimately a fairly inoffensive word, shows just how badly the financial industry and the government between them have shredded our faith in pensions.

But relax. Put aside your prejudices.

Like anindividual savings account (Isa), a pension is just another container that you can put your savings in if you want to protect them from tax (which we do).

Nothing more, nothing less.

Sure, they aren't quite as straightforward as Isas, but they're nowhere near as complicated as the financial industry makes them sound.

And despite the frequent bad press they get, they will almost certainly form at least part of your long-term savings plan.

So here's your pain-free guide to understanding how they work.

Let's look at the basics first. Pensions come in various forms. There's your state pension. That's the money the government will give you when you reach a certain age. You can't know how much it will be, but you can be sure that on its own, it won't fund anything more than a very basic lifestyle when you retire.

Your employer may offer a pension. If you work for the public sector, you will probably have some sort of defined benefit pension. This means you know what you will get when you retire. The end sum will be based on some combination of your final or average salary, and your length of service.

This is a great benefit. It puts all the investment risk on the employer. You know what you'll get it's up to them to make sure they can provide it.

Perhaps unsurprisingly, this is precisely why very few private sector employers offer these pensions any more. And with the government heavily in debt, the benefits are being eroded in the public sector too. So even if you have one of these pensions, you should still be making other provisions for your retirement.

Most private sector workers with a company pension will have a defined contribution pension. This means you pay in a certain amount, but what you get in the end depends on how your investments perform between now and when you retire.

If your company offers one of these pensions, and will match your contributions if you pay into it, you should take them up on the offer. It's free money effectively.

Yes, you might not like the investment options on offer. But if you're putting in 5%, say, and the company is matching that, then you've made a 100% return right away.

So the investment performance will have to be really bad before you've actually lost money on the deal.

Want to take charge of your own pension fund? This is where the self-invested personal pension (Sipp) comes in. You get to choose exactly what to buy, and you can make changes as frequently or infrequently as you like.

The tax benefits

With a pension, on the other hand, the government gives you your tax break up front. What do I mean?

Say you're a basic-rate taxpayer. When you pay £80 into a pension, the taxman grosses it back up to £100. (In other words, you get back the 20% tax you paid on that £100 when you earned it).

If you're a 40%-rate taxpayer, you only have to pay £60 to make a £100pension contribution.You get the £20 basic rate tax back from the taxman immediately, and thenyou can claim back a further £20 on your self-assessment form.

There are limits on this tax relief. Currently, the annual limit is £50,000 a year, with a lifetime limit of £1.5m, so you can put plenty of money away.

The flipside is that income generated by a pension is taxable. When you access your pension, you can take a 25% lump sum tax-free. The rest must be used to provide a retirement income.

For most people, this will be in the form of an annuity (an income stream that you purchase with your pension pot), although there are other options. We'll look at these in more detail later on.

But the key point is that income from an annuity or anything else you do with a pension, is liable for income tax.

What does this all mean in practical terms? You can see how they compare in this piecemy colleague Phil Oakley wrote for MoneyWeek magazine: How to get the best income from your pension pot.

But to sum up, in terms of the numbers, for basic rate taxpayers, there isn't a huge gap between pensions and Isas. The tax-free lump sum is the main advantage enjoyed by the pension.

For higher-rate taxpayers, pensions win out. This is because the tax relief is particularly generous.

It's even better if you end up in a lower-rate tax band once you're retired (which is quite likely): you get higher-rate tax relief going in, then only pay lower-rate tax going out.

There's just one catch.

The trouble with pensions

That might not be such a problem if you could trust the pot to just sit there but you can't. The big problem with pensions is that the government can fiddle with them at any time.

And they do. The pensions rules change with every Budget.

Of course, the government can change the Isa rules any time it wants too. The difference is that you'd be able to withdraw your Isa money if you felt you had to. A pension is stuck there.

Which one to do now

The ideal would be to get as much higher-rate tax relief as you can each year out of your pension, then shift focus to your Isa. In other words, if you earn over £42,385 a year, save what you can over and above that amount in a pension to benefit from the higher-rate tax relief.

But you may not be able to save that much. You may also prefer the flexibility of the Isa over prioritising the pension tax relief.

Alternatively, you might like the idea of your money being locked away until you're older, so that you can't get at it early. (Although you should also realise that this implies that you trust yourself less than you trust the government!)

My own view is that if your employer will contribute to a pension along with you, take maximum advantage of that. Once you've sorted that out, focus on filling up your Isa. After that, top up your pension..