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Guide to Personal Pensions

Introduction

Personal pensions are an essential part of long-term retirement planning.

In essence, they are private “money purchase-style” savings schemes, where money is paid into a fund, which is then invested. The proceeds are used to buy an annuity (a regular income) at retirement.

Here are some of their key features of a personal pension:

• Payments can be either monthly or by means of a lump sum, usually at the end of a tax year, when you know how much you are likely to have earned over the previous 12 months.

• Contributions are based on a series of limits determined by the Inland Revenue, of which more further down.

• The investor has a choice of assets into which his or her money should go.

• Retirement can take place at any age between 50 and 75. This limit is set to be raised to 55 from 2010.

Some people can take their pensions earlier than age 50. For example, cricketers can retire at 40, as can divers, speedway racers, golfers and trapeze artists. National Hunt jockeys and footballers can quit at 35 – those on the flat need to wait until they are 45. But downhill skiers can retire at 30.

Benefits of a personal pension

The advantages of a personal pension are significant:

Tax relief on contributions: the government offers generous tax concessions to those who pay into personal pensions.

For every £100 paid into one, basic rate taxpayers only have to contribute £78. The Inland Revenue pays the remaining £22. This will change from April 2008, when the basic ate of tax moves to 20 per cent.

The position for higher-rate taxpayers is even better: they can also claim back an additional 18 pence for every pound of contributions when they fill in their tax forms.

Money inside a pension fund rolls up free of tax.

A tax-free lump sum: when a personal pension is finally cashed in, a policyholder has the option – though not the obligation – to take up to 25 per cent of the final lump sum as tax-free cash.

Although a similar option is also available for company pension schemes, the way they calculate their tax-free cash is highly complicated.

Is there a downside to personal pensions? Well, there are two main ones:

1. The income you receive from a pension is taxed. But most higher-rate taxpayers revert to the basic tax rate after retirement, making personal pensions a tax-efficient vehicle.

2. Annuities must be bought with the pension pot before the age of 75. This can mean that if the annuitant dies shortly after taking out an annuity, his or her estate may not receive a penny of that pension pot. But there are many ways round the issue and many companies can advise you accordingly.

If you die before the annuity is bought, your pot does pass on to your estate, subject to tax if over the IHT limits (£300,000 as of April 2007, rising to £350,000 by 2010).

One exception is if your pension pot is based on contributions from a so-called “contracted-out” pension, made up of a National Insurance rebate (a government bribe for not taking up your entitlement to the Second State Pension, or S2P). Such pensions have a “protected rights” which be used to provide a regular income for your dependents.

Personal pensions and occupational pensions

Once, you could not have an individual pension if you also had an occupational pension.

However the rules changed with the introduction of the stakeholder pension. You can now contribute to a personal pension (or a stakeholder one) if you have earned less than £30,000 per year in any of the last five tax years.

Contributions limits

The Inland Revenue imposes limits on the amount of contributions into personal pensions. They apply to gross earnings in any tax year.

Since April 2006, the government has introduced a single “lifetime allowance” on the amount of pension savings that can benefit from tax relief. This was set at £1.5m on introduction, rising as follows:

2007 - £1.6m
2008 - £1.65m
2009 - £1.75m
2010 - £ 1.8m

This will be reviewed every five years.

If you go over the lifetime allowance you will pay 25 per cent tax on that part of the pension. If you take a cash lump sum over and above the lifetime allowance you will be taxed at 55 per cent on it. Contributions over the allowance will be taxed at 40 per cent.

An annual contribution limit of up to 100 per cent of relevant earnings (or £3,600 if a person earns less than that), up to £215,000 will apply in any one year.

Who and when are personal pensions suitable for?

• Anyone who is self-employed

• Employees where no company scheme is available

• When some of the benefits from a company scheme are not applicable to their personal circumstances. For example, many schemes offer a dependents’ pension after the main holder’s death. But if you are unmarried and without children, it may be better to have a personal pension where you can design the benefits to suit yourself. In such cases, it is essential always to talk to an independent financial adviser first

• When the main scheme’s investment strategy is massively out of kilter with your own (either on ethical or performance grounds)

More pages

Page 1: Introduction
Page 2: Stakeholder pensions?

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