Why it’s so important to understand how your pension works

For many people, retirement is a time to relax and enjoy the rewards of your lifetime of hard work. You may already have thought about what you want to do, whether that’s taking long holidays or simply spending more time with your loved ones. 

Of course, if you want to be able to live your desired lifestyle, it’s important to have enough wealth to support it. According to recent research by Aviva, while more people are saving into their pensions than ever before, many Brits don’t fully understand the rules surrounding these investments. 

This is worrying news, as being able to make informed decisions is essential for helping to grow your wealth in an effective way. Read on to find out why it’s so important to fully understand how your pension works. 

It’s important to have enough wealth if you want a comfortable and sustainable retirement 

If you want to enjoy a comfortable retirement, being able to make properly informed decisions can help you to grow your pension wealth effectively. 

For a start, it’s important to know how much you can tax-efficiently contribute into your pension each tax year (6 April to 5 April). In the 2021/22 and 2022/23 tax years, this stands at £40,000 or 100% of your earnings, whichever is lower. 

Tax relief can be a useful way to help grow your wealth, so it’s important to understand how it works and how much you can claim. 

Whenever you make a contribution, some of the amount that you would normally have paid in tax is transferred directly into your pension instead. The amount that you can receive depends on the rate of tax you pay, meaning that if you’re: 

• A basic-rate taxpayer, you’ll receive 20% tax relief on your contributions 
• A higher-rate taxpayer, you’ll receive 40% tax relief on your contributions 
• An additional-rate taxpayer, you’ll receive 45% tax relief on your contributions. 

However, only the basic rate of relief is added to your pension automatically. If you pay the higher or additional rate of tax, you’ll have to complete a self-assessment form in order to claim the extra 20% or 25% that you’re entitled to. 

Of course, when aiming to build your wealth, it’s also important to be aware of the Lifetime Allowance, which is the total amount that you can save into your pension tax-efficiently. In the 2021/22 and 2022/23 tax years, this stands at £1,073,100 and covers the total value of all your pension assets including both defined contribution and defined benefit schemes. 

When the time comes to draw from your pension, or at age 75, a Lifetime Allowance test will be applied. If the value of your combined pensions is greater than the limit, you may have to pay a charge on the value above the threshold.  

You may also be liable for a tax charge of 55% of any excess taken as a lump sum or 25% of the excess if taken as regular income. 

Knowing how to make sustainable withdrawals could avoid the risk of running out of money 

Retirement is supposed to be a time to relax and enjoy the lifestyle you want, which is why it’s understandable that many Brits are worried about running out of money in this chapter of their lives. 

According to a recent study published in This is Money, almost half of retirees are concerned about this prospect. If you want to avoid the risk of this happening, it can be important to carefully plan how you withdraw your wealth.  

For many years, the rule of thumb for pension withdrawals was that 4% was a sustainable amount to take out of your pot each year. However, given that market conditions have changed significantly since it was first proposed in the 1990s, it may not be still applicable. 

For example, thanks to advances in medicine and technology, you’re likely to live longer than a retiree from 30 years ago. Furthermore, since interest rates are now far lower than they were in the 1990s, this may affect the returns on assets such as corporate and government bonds. 

Knowing how much you can sustainably withdraw from your pension can help to give you a much greater sense of confidence that you won’t run out of money in retirement. 

Working with a planner can help you to make informed decisions with your wealth 

When it comes to retirement, there can be a lot of important things to think about. Not only do you need to consider issues like contributions and sustainability of withdrawals, but there may also be the risk of incurring significant tax charges. 

If you want to enjoy a comfortable and sustainable retirement, seeking professional advice could be helpful. For example, it can help to ensure that you make the most of your allowances to build your wealth in the most effective way possible.  

It can also be invaluable if you’re nearing your Lifetime Allowance and want to avoid triggering any tax charges that may eat into your wealth. 

Finally, working with a planner can help you to find a sustainable annual withdrawal amount, giving you more peace of mind that you won’t run out of money in retirement. 

Get in touch 

If you want to know more about how you can potentially grow your pension wealth in a more effective way, we can help. Please email us at advise-me@fosterdenovo.com or call us on 0330 332 7866 to speak to one of our team. 

Please note: 

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor. 

Workplace pensions are regulated by The Pension Regulator. 

Foster Denovo Limited is authorised and regulated by the Financial Conduct Authority.