Pension rules
Tax benefits
The rules on pensions can change with the seasons, but some basic things have remained constant in recent years:
- Investors get income tax relief on their contributions into a pension scheme (up to certain limits – see below)
- The income and gains made by that fund roll-up free of additional tax whilst the money remains invested
- At retirement, you can take a tax-free lump sum of up to 25% of the total fund value
- The remainder of the fund is then used to provide an income which will be taxable at your marginal income tax rate
Annual contribution limits
For the 2011/12 tax year, the maximum amount you can invest into your pension, personal or occupational, is 100% of your income or £50,000, whichever is the lower. For these purposes, income is defined as your UK derived taxable earnings, including salary, dividends, interest and trading income. You will receive tax relief on the entire investment, up to that limit. However, if you try to invest more than £50,000, you will have to pay tax at 40% on the excess. This limit, incidentally, applies to the combination of both employee and, if applicable, your employer’s contributions. You can, however, carry forward up to three years unused allowance to subsequent tax years.
Lifetime allowance
The lifetime allowance applies to the total value of all private and work pensions (not state pensions) that you build up over your lifetime, including the investment growth you achieve. For 2011/12, this value is £1.8 million. If your pension funds grows above this value then you will be liable to tax charges on the excess. And these charges are quite onerous – 55% if the amount over the lifetime allowance is paid back to you as a lump sum and 25% if the amount over the lifetime allowance is taken as some form of income. If you have a large pension fund already, therefore, even if it has not yet reached the lifetime allowance, you have to consider whether there could still be some investment growth to come. For example, if your pension fund is valued at £1.4m and you have 10 years still to go, it might be time to stop making contributions and find somewhere else to put your savings.
Building a pension portfolio
Choosing a type of pension is important, but the contribution you make and your choice of underlying investments will have the greatest impact on your long-term wealth. The investment choice within pensions has evolved from the days of the traditional life office products with a selection of one or two balanced funds. Now, most pensions offer a sufficiently broad choice of investments for you to build a truly individual portfolio.