Tax relief, investing, State Pension: the biggest pension myths
Falling for one of these myths or misconceptions can hurt the size of your eventual pension pot.
Pensions are a necessity for the vast majority of us, who want to take some steps now to ensure that we can enjoy some level of comfort in our retirement.
However, there are an awful lot of myths and misconceptions around pensions that can negatively impact the way we approach our retirement saving.
What’s happening to my money?
A big issue here is the confusion over what happens to that money when we hand it to a pension firm.
A study by Hargreaves Lansdown found that just a third of pension savers realise that the money is invested in the stock market, with another third actively believing it isn’t invested.
This blind spot is particularly acute for women ‒ only one in four knew that the funds are going into stocks and shares rather than cash.
To an extent, this is understandable.
We talk about pension saving rather than investing, after all.
But this lack of engagement doesn’t help people to make proper plans for their retirement, or to even follow how their pension is performing.
Automatic tax relief
One of the perks for higher earners when it comes to pension contributions is that they enjoy a greater rate of tax relief.
The relief is based on your marginal tax rate, so while Basic Rate taxpayers get relief at 20%, Higher and Additional Rate taxpayers get tax relief at 40% and 45% respectively.
That can make a big difference the eventual size of your pot too. For a Higher Rate taxpayer, it means that for every £60 they pay in, the Treasury effectively tops it up by a further £40.
The trouble is, those higher contributions aren’t necessarily automatic.
It all comes down to the type of workplace pension you’re saving into.
If the pension scheme operates a ‘net pay’ arrangement, then the contributions are taken from your salary before Income Tax is paid.
Your scheme then claims back the contributions at your highest rate of tax, meaning you don’t have to do anything.
It’s worth noting that ‘net pay’ arrangements have led to real issues in the past, with lower-paid employees not getting any tax relief at all.
Other pensions operate on a ‘relief at source’ basis.
With these, your employer takes 80% of your contribution from your salary, with the pension scheme then requesting the other 20% from the taxman.
This is fine for Basic Rate taxpayers, but Higher and Additional Rate taxpayers will be missing out on relief that they qualify for.
In these instances, they will have to complete a Self Assessment tax return in order to gain the correct amount of tax relief.
Tax on withdrawals
Some people are sceptical about pensions, arguing that the tax relief paid on contributions is cancelled out by the fact you are then taxed on your pension income.
This isn’t entirely true though.
Firstly, you can take a 25% tax-free lump sum from your pension.
That could be a significant amount of cash, depending on how well you’ve done squirrelling money away during your working life, and the taxman doesn’t get to touch a penny of it.
Similarly, it’s worth remembering that the tax you pay on your pension income is based on your overall income at that time, and so may be rather different from the tax relief received on your contributions.
For example, if were a Basic Rate taxpayer, you got 20% tax relief on your contributions. If your pension income in retirement is lower than the Personal Tax Allowance then you won’t pay any Income Tax on it at all.
It’s the same for those who were Higher or Additional Rate Taxpayers during their working life, but who may be Basic Rate taxpayers ‒ or even pay no Income Tax ‒ in retirement.
I can catch up later
It can be very easy for younger people to delay starting a pension. It’s only something you need to worry about in later life, right?
Anyway, I need to save a deposit, pay off my student loan, etc.
While it’s true that you may be able to catch up somewhat later on, the reality is that it will end up costing you far more than if you simply get started with a pension early on.
That money compounds over time, so the longer it has to work its magic, the better off you’ll eventually be.
Nobody ever gets to retirement and wishes they had saved less in their pension, but there are an awful lot of people who reach later life and wish they had started saving earlier.
The State Pension will look after me
The State Pension is a fantastic safety net for retirees, but let’s be clear, it’s not going to lead to much comfort in your twilight years.
A study last year by Investing Reviews dug into how the State Pension in each country compares to the typical pre-retirement earnings of workers there.
And Britain’s State Pension doesn’t look great, representing 28.5% of those pre-retirement earnings, ahead of only Mexico and South Africa.
By contrast, the State Pension in Italy, India, Turkey, Bulgaria and Luxembourg provides upwards of 90% of those pre-retirement earnings.
Recent Governments have not exactly hidden the fact that, with an ageing population, the cost of maintaining the State Pension is enormous.
That’s why we have seen increases in the State Pension age, with more to come.
Ultimately relying on the State Pension is a risky gamble.
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