When you think of a pension, what do you think of? What is it exactly?
As part of Magical Penny’s pension series, this article will teach you what a pension is and how you can benefit from understanding about how they work.
Like most financial products, a pension isn’t much in itself. In fact a pension is nothing but a tax position, a hollow shell of a product.
One great way to think about financial products is that they are like envelopes. They come in all different shapes and sizes and each have their specific uses. On their own there’s nothing special about them, but fill them with money and things start getting interesting.
For not all envelopes are the same…
A normal savings account is like putting your money into a paper envelope. It’s good for keeping your saving separate from your main current or checking account but it’s not protected from the rain of taxes. You’ll be left with a soggy envelope with less money over time than envelopes protected from the rain of taxes (because you’re taxed on any interest you may have earned).
Tax Proof Saving
Rather than a paper envelope, a pension (or a 401k in America) is like a water-proof envelope that allows your money to grow without being rained on by taxes. You don’t have to pay taxes on the money you put into a pension and your money can grow much faster because the growth isn’t taxed either. Instead, you are taxed only when you take it out when you retire.
An ISA or a Roth IRA works the same only you pay taxes before you put money in rather than when you retire!
In the UK, as an added incentive to contribute to pensions, current tax law allows you to take 25% of your pension pot as a tax free sum when you retire –a double tax saving.
Whilst being ‘waterproof’ from the rain of taxes, the downside to pension ‘envelopes’ is that it is difficult and costly to open if you need the money before retirement. In the US cashing out a 401k retirement vehicle costs 10% of the amount plus your tax rate so it is very expensive to get access.
And for Britons it’s actually impossible –pension envelopes are super-glued up! In the UK, people cannot currently access any portion of their pension funds before the age of 55 ( as of this year, 2010).
Filling the Envelope
There are pros and cons to saving in a pension but the tax implications are meaningless if the money inside the envelope is not growing. The main question is therefore with what should you be filling your pension envelopes? As pension envelopes come in many different shapes and sizes so the answer is: it depends!
- The State pension: You can’t control this as the state controls the pay-out rates. Working out your pension requires a complex set of calculations. If you want to get an estimate of your SERPS pension the best way is to get a pension forecast from the Pension Service website. There’s also more information in Magical Penny posts on The UK State Pension and The UK State Second Pension.
- Final Salary Pension: You pay into this type of pension but your employer then decides what they are going to invest in. The responsibility is on them to get sufficient growth to pay you your pension when you retire. These types of pensions are increasingly rare because companies are unwilling to take on the risk of getting an adequate investment return –if the investments do not grow as expected they are left with huge pension deficits which can be damaging to them.
- Personal Pension (Or 401k). If your company has a pension scheme that is not a ‘final salary’ scheme you’ve most likely got a personal pension. The number of investment options tend to be limited by the scheme that you are in and most people tend to go with the default suggestion. By the way, you don’t have to: in future posts Magical Penny will be explaining what to look out for having recently gone through the process.
- Stakeholder Pensions: Similar to personal pensions but set up by the UK government to encourage companies to provide pensions for lower income workers (those earning up to around £18K). They have stricter rules including that the investment options must be low charge (1% or less). Personal pensions on the other hand offer more choice but can charge what they want.
- SIPP –Self Invested Personal Pension (Or Self Directed 401k). These pensions offer almost unlimited flexibility to invest in anything you want, all the while ensuring your gains are not taxed. You can invest in individual shares and property, even gold and other commodities. Whilst the options can be great, it can be risky and is not for the faint hearted. But they can be the best way to ensure you pay the lowest fees and are not at the mercy of a limited and fee-bloated pension provider.
Remember, pensions are just envelopes
Hopefully this post has helped you understand pensions a little better. They are merely water-proof envelopes that stop your money from being washed away by the rain of taxes. There may have slightly different rules and options but they all simply allow you to put money away without paying tax until you retire.
It’s a little more complicated knowing what to put in your pension but the most important thing is getting one in the first place. You can always tweak and transfer later on but the sooner you start stuffing money into them the more money you’ll have to grow tax free.
Whilst pensions are important they are not your only option. As I explain in this video, ISAs may be a better choice for you right now:
Pre Tax and Post Tax Investing -Which is better? [Magical Penny] from Magical Penny on Vimeo.
What do you think? Share your thoughts in the comments.
Read the rest of Magical Penny’s pension series here.