How do pensions work?

Paying into a pension, tax relief, contribution limits, fees and accessing or withdrawing from a pension.

At their core, pensions are fairly simple. You pay money into your pot while you work and take the money back once you've stopped. In this article, we'll take a look at what you need to know about how pensions work.

How do pensions work?

Once you know what a pension is, next up is learning how they work. While it does vary by the type of pension you have, on the whole, UK pensions follow 3 very simple principles:

  1. You (and your employer) contribute into your pension pot
  2. The government tops up your pot with a 20% (or higher) tax bonus
  3. From age 55, you start to use your pension for an income in retirement

The money you save into a pension is called a contribution. You can pay into your pension via one-off lump sums, regular monthly payments, annually, or a combination of all three.

How much you save is up to you. A rough figure to aim for is 15% of your pre-tax income, although this varies significantly depending on when you start contributing.

If you’d like more guidance on saving, check out our article on how much should I contribute into my pension or use our handy pension calculator to forecast your pot come retirement.

Now, let’s take a quick look at the three main elements that make a pension tick: how you save, how your pot grows, and what happens when you're ready to withdraw your money.

Paying into a pension

Everything you pay into your pension is invested into a pension fund. The idea is that, over time, the investments inside this fund will grow, leaving you with a much larger pot than if you had just kept the money in a regular bank account.

To get the most out of your retirement, there are a few things you'll want to keep in mind when it comes to contributing into your pension.

Take advantage of tax relief

Whenever you pay into your pension, you'll benefit from tax relief. The UK government tops up your contributions by applying a minimum 25% tax bonus. So, if you add £100 to your pension, the government will add £25 extra free

For more information on tax relief, including how this affects higher rate taxpayers, check out our article tax relief on pension contributions.

Watch out for limits

You should also be aware of the various limits on pension benefits.

From the 2024/25 tax year, tax relief is capped at either £60,000 or 100% of your earned income, whichever is lower. This applies across all your pensions, not each pension plan. If you aren’t employed or earn under £3,600 annually, then the most you can pay into a pension is £2,880 (or £3,600 with the 25% tax relief applied).

There are also limits to how much you can hold in a pension over your lifetime and still enjoy tax relief. This is called the Lifetime Allowance (LTA). For 2022/23 your pension is capped at £1,073,100 and this includes any growth that comes from your investments.

The government announced that from 6 April 2023 the lifetime allowance charge would be removed. The lifetime allowance will be fully abolished from the 2024 to 2025 tax year, through a future Finance Bill.

Pension Fees

Like most financial services, your pension provider will charge a fee. Here's a quick rundown of the most common costs you may run into.

  • Annual Management Charge (AMC): The annual management charge is the fee charged by a pension provider for the administration of your investments. This is normally a fixed amount and may depend on the size of your savings pot.
  • Fund Management Charge (FMC): There may be a fee associated with the management of each fund in your portfolio. Sometimes providers can reduce or remove fund management charges if they have an agreed arrangement with the fund management company.

Other costs and fees

  • Set-up fee: It's uncommon now, but some providers may charge a fee for setting up a policy.
  • Platform fee: Some providers may use a platform or service to host their pension funds - letting you choose new investments and move your pension savings around. This service sometimes incurs a charge.
  • Transaction fee: This can also be known as a 'switching fee'. It’s a charge that applies when you buy and sell investments.
  • Exit fees: Some pension providers will charge a fee to withdraw or transfer money to another plan. 

Accessing your pension

For most, the earliest you can start withdrawing from your pension is when you reach 55.

The majority of private personal pensions (including defined contribution workplace pensions) can be accessed from age 55 (expected to increase by 57 by 2028). Some defined benefit workplace pensions may have set retirement ages specific to the scheme, so it’s best to check any paperwork you have or give your pension provider a call.

You may have also set a target retirement age when you set up your pension. This helps your pension provider know when to contact you about your options for retirement. Be sure to check the funds you're invested in too, as this may affect when you want to start taking your money out.

What are my retirement options?

Once you reach 55, there are a number of options available to you.

Firstly, you can leave your pot invested if you’re not ready to start to take any income from your pension. You can also continue to pay into your pension. There are limits, however, if you do decide to take any income from one or more of your personal pensions. This is dependent on the type of policy, and how you withdraw the money.

There are four different ways you can access your pension savings: taking your full pot, lump sums, drawdown, or taking out an annuity, each with its own pros and cons.

If you’re eligible, you can also claim your State Pension starting at age 66 (for 2020/21).

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1. Get a Penfold account by registering your details online or with our app.

2. Transfer an existing pension, or make a one-off or recurring payment (pause or adjust any time).

Done! Check savings progress, change investment plan and more with our app or online dashboard.

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