Unless you are living under a rock (or maybe you just don’t like the news as much as I do) you will of heard recently that the stock markets have been going through a rather turbulent spell.
Caused by recent problems with the Chinese economy, stock-markets around the world, not least the Chinese stock market, have been crashing – dragging down the FTSE 100 and the investments of many pension funds with them.
However it is worth bearing in mind that the impact that financial crashes such as the one going on at present have on pension pots tends to be evened out over time, and also by a balanced portfolio of investments in different industries and products by the pension companies.
Which type of pension you have also has an impact. At DumbFunded, we are not pension experts, so we thought we would do a little research to try and boost our understanding.
Read on for our quick guide to personal pensions: what they are, how they work, and more.
Important: Note that no part of this article should be considered as financial advice – always speak to a pensions or finanial expert before making any decision, and you should note that the value of investments can go both up and down.
What is a Personal Pension?
There are various types of pensions out there. One type is a personal pension, which specifically is a type of ‘defined contribution’ pension.
With a defined contribution pension, users slowly build up a pot of money that can then be used to help provide an income once you have retired.
Unlike a defined benefit pension schemes, which specify a particular income, the income you can get from a defined pension scheme depends on factors such as how much you pay in, the pension fund’s investment performance and the choices you make upon retirement.
Some experts say that a personal pension can be a good way of saving for retirement for people that do not already have a workplace pension.
Tax
If you pay tax at the basic rate your pension provider will claim tax relief for you at the basic rate and add it to your pension pot.
If however you are a higher rate tax payer then you are required to reclaim the addition rebate through your tax returns.
How do Personal Pensions Work?
Like essentially all other types of pensions, the more you pay in to your pension, the bigger the pot should grow.
However unlike some other pension types, there are other factors that influence how much you get back later as income – as we have already mentioned – including factors such as how successful the pension company’s investment funds were – and how exactly you choose to cash in your pension upon retirement.
When describing how personal pensions work, it helps to think of personal pensions as having two stages.
Stage 1: whilst at work – during this stage you would usually choose exactly which investment funds you want your pension fund to invest in – and depending on the markets etc these funds can then either increase or decrease in value.
The Money Advice Service (MAS) has a great article on pension investment options here that you might find useful. Always be careful and speak to an expert before making any decision.
Stage 2: when you retire – once you have retired you can now access your pensions funds with your own method of choice, from the following options:
- Cash in your entire pension pot in one lump sum. 25% of this willbe tax free, the rest of the cash will be subject to income tax. You might also potentially find that the money pushes you up a tax bracket.
- Take the cash in multiple lump sums, as and when you decide you need them. As with taking the entire pension as a lump sum, each individual lump sum you request will have a 25% tax free portion and the remainder will be subject to tax.
- Take a quarter (or the amount you allocate) as a tax free lump sum, and leave the rest to be distributed to you as a regular and taxable income.
- Take a quarter as a tax free lump sum, and convert the rest into an annuity (a taxable retirement income).
Pension Reviews
Still following us after the above? Well done – this isn’t easy stuff and you have a lot of potential options. As we said in the disclaimer at the beginning, this article should in no way be considered financial advice – with any financial product it is generally advisable to speak to an expert before making any decision.
In the case of pensions, one avenue is to get a pension review (more info on these here), or basically to speak to a pensions adviser.
Pension advisers can help talk you through the options available to you, can help discuss your existing pensions, and talk you through getting a new pension if you are yet to arrange one.
If you have any specific questions or comments feel free to leave them at the end of this article and we will do our best to answer them or forward them onto an expert who can help.
Main image adapted from a photo of a couple on Musselburgh beach in Scotland by Ronan @ Flickr.
