Do you know how your pension works?
This technical guide provides information about defined contribution pensions, how they work, their taxation and benefits. This type of plan may also be known as a personal pension or money purchase pension.
What is a defined contribution pension?
Within a defined contribution pension, you build up a ‘pot’ of money which can be used to support you in retirement. The amount available at retirement is based on the contributions paid into the plan and the performance of the underlying investments.
Tax-relief
Personal contributions into a defined contribution pension plan are generally made net of basic-rate tax. This means that for every £80 you contribute, £100 will be credited to your pension. Higher and additional-rate taxpayers can reclaim further tax through self-assessment. However, there are limits to how much you can put into a pension, this is known as the annual allowance.
Funds within the pension grow free from income tax and capital gains tax.
Investments
You can choose which funds to invest your pension in, and the majority of providers now offer a large range of potential funds. It’s important to ensure that your pension funds are diversified and in line with your risk profile. If you’re in an auto-enrolment workplace pension scheme, there will be a default fund available.
Security
The value of a defined contribution pension is not guaranteed and will go up and down in line with the funds it is invested in. At retirement, unless the funds are used to purchase an annuity, a defined contribution pension does not provide secure income.
When can I access my benefits?
At present, you can access benefits from your defined contribution pensions from age 55. However, the normal minimum pension age is set to rise to 57 in 2027.
However, dependent on the scheme rules, some pensions that were already in force in 2021 will be able to retain an access age of 55.
Options at retirement
At retirement, there are three options in terms of accessing your benefits:
Annuity
The option of an annuity allows you to exchange the benefits you have built up in favour of a secure income that will be payable for life.
Flexi-access drawdown
With the option of flexi-access drawdown, your funds will remain invested and you can take your benefits flexibly as and when required.
Uncrystallised Funds Pension Lump Sum (UFPLS)
This option allows you to access the full pension value as a lump sum. However, if you do access all your funds at once there may be a large tax charge.
There are advantages and disadvantages to each option and what’s right for you will depend on your personal circumstances and objectives. You can read more about each of these options in our Guide to Retirement Options.
Taxation of your pension income
Defined contribution pensions allow you to access up to 25% of the fund value as a tax-free lump sum from the normal minimum pension age (currently 55). You don’t have to take all benefits at once and can take your benefits in stages for tax efficiency.
All withdrawals above the 25% tax-free cash are subject to income tax through PAYE. It’s important to manage your withdrawals carefully to ensure you don’t pay more tax than necessary.
Death benefits
Defined contribution plans offer considerable flexibility in terms of death benefits. You can nominate one or more beneficiaries to receive your pension fund in the event of your death through completion of an Expression of Wish form.
Your beneficiaries will have the option to access the full fund as a lump sum, enter flexi-access drawdown or purchase an annuity. In addition, in the event of your death before 75 the benefits are usually payable tax-free.
Risk warnings
· The information in this guide is based on current taxation and legislation. Changes to pension rules may affect your entitlement to access to your pension fund and benefits available to your loved ones.
· Future changes to the taxation of pension fund assets could also have an adverse effect on long term investment returns.
· This guide is designed for information purposes only and is not intended to replace advice. The pension option that is right for you will depend on many factors and we would always recommend that you take advice from a qualified professional.
