Five tricks to boost your pension

Although pensions are often seen as boring, these five features help to spice them up!

The most common word I hear used to describe pensions is 'boring'. There is something in this -- after all, how exciting does saving for retirement get?

In fact, more than five years ago, pensions got a whole lot more interesting. On 6 April 2006, a host of existing pension regulations was replaced by a cut-down set of rules. Following what became known as 'Pensions A-Day', saving for retirement became a whole lot simpler and -- dare I say it -- spicier.

Five pension bonuses

Here are five reasons why a pension is an attractive tax shelter to fund your retirement:

1.     Get free money from your boss

Here's a statistic to show how much employees value their workplace pensions: two in five people who could join company pension schemes fail to do so. In effect, this means that 40% of workers are turning down free pay from their employers.

That's because many employees -- especially larger businesses -- contribute directly to their workers' pension pots. This may take the form of a percentage of salary being paid in by the employer, typically 5% to 15% of before-tax salary.

Even better, roughly 2.5 million private-sector workers and 5.5 million in the public sector are members of final-salary pension schemes. These are the gold standard of pensions, providing guaranteed pension payments based on salary and length of service.

Hence, if you haven't joined your company pension scheme, then what are you waiting for? Do you have a habit of turning down free money?

2.     Take money from the taxman

When you pay money into a pension, the taxman also chips in by giving you your tax back. How much tax relief you receive depends on your tax rate.

For basic-rate (20%) taxpayers, a £100 pension contribution is made up of an £80 personal contribution, plus £20 of tax relief paid directly into the pension by HM Revenue & Customs.

For higher-rate (40%) taxpayers, a £100 contribution consists of an £80 personal contribution, plus £20 in tax relief paid into the pension, plus a £20 tax reclaim after the tax year ends (usually via tax returns or adjusted tax codes). In effect, the net cost of this contribution is £60.

For additional-rate (50%) taxpayers (those earning £150,000+ a year), a £100 contribution consists of an £80 personal contribution, £20 in tax relief paid into the pension, and a £30 tax reclaim. In effect, the net cost of this contribution is £50.

This 'tax back' can even be claimed by non-workers, up to a maximum personal contribution of £2,880 per tax year (£3,600 including 20% tax relief).

3.     Enjoy tax-free growth

Tax relief on contributions isn't the only tax break provided by pensions. All capital gains and income produced inside pensions are free of tax, too.

Thus, all gains from rising share prices, property gains and other growth are free of Capital Gains Tax (CGT). In addition, all income -- savings interest, share dividends, bond coupons and so on -- is not directly taxed inside pensions.

Over time, this extra tax break makes a big difference. For the sake of argument, let's compare two funds: the first produces a taxed return of 8% a year, while the second grows by an untaxed 10% a year.

Here's how a lump sum of £1,000 would grow inside both funds:

As you can see, after four decades, the untaxed fund growing at 10% a year is worth over £45,000, versus less than £22,000 in the taxed fund growing at 8% a year. Therefore, pensions are a great tax shelter in which to grow your wealth.

4.     Get tax-free cash

When you reach the age of 55, you can start drawing on your pension. At this point, another tax break appears: the right to withdraw a quarter (25%) of the value of your pension as tax-free cash.

For example, if you have a fund worth £200,000, then you can take out up to £50,000, free of tax, to spend as you wish. You could use this tax-free lump sum to reduce your mortgage, buy a tax-free income inside ISAs, or splurge it on the holiday of a lifetime. The choice is yours...

What's more, you don't have to take out all of your tax-free cash in one go. You can take it out in stages, so long as you don't exceed the 25% limit.

5.     Use the open market option

Finally, after patiently saving into a pension for decades, you'll reach the point where you need to turn your pension pot into a retirement income. Most people do this by buying an annuity: a guaranteed income paid for life by an insurance company.

(Though some experienced investors opt for phased payments known as 'income drawdown' or flexible drawdown, these are best suited to those with pots worth £200,000+.)

The good news is that you don't have to buy an annuity from the pension provider you've been saving with for all those years. In fact, you have a legal right -- known as your ‘open-market option’ (OMO) -- to shop around for the highest annuity payouts. The best way to search this market is via a specialist annuity broker such as Hargreaves Lansdown, Just Annuities or the Annuity Bureau.

Poverty is boring

So, there you have it: five qualities that make pensions the ideal tool for saving for retirement. If you still think pensions are boring, then just think how dull it would be to retire broke and live on the breadline!

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