A defined contribution pension is a type of private pension used in a workplace pension or a personal one.
Private pensions can be defined benefit or defined contribution pension plans. The amount an employee will get on their retirement in a defined benefit pension is based on their salary whereas the pension income one gets from a defined contribution pension is based on the number of payments they’ve made and how well these savings have been invested. In this blog, we’ll discuss the defined contribution pension and how it works.
There are several types of defined contribution schemes:
- auto-enrolment pension
- SIPP (Self Invested Personal Pension)
- Group Personal pension
- Stakeholder pension
- SSAS (Small Self-Administered Schemes).
Nowadays, the majority of workplace pensions are defined contribution ones.
Husky is an expert in workplace pension schemes. We try to instil confidence in our customers by explaining pensions and how they work. Let’s have a look at how a defined contribution pension works.
How does a defined contribution pension work?
A defined contribution pension works more straightforwardly compared to a defined benefit pension. A contribution one is all about saving to a pension pot every month, and investing these savings to potentially grow the pot even more. As with all investments though, pension value is not guaranteed as it can go up as well as down.
As explained previously, the amount of pension income an employee gets in their retirement depends on the number of contributions they make throughout their career and how well these funds have been invested.
By law, contributions to a workplace pension have to be made by both employee and employer. The total minimum amount of contributions should be 8%, with the employee contributing 5% of their qualifying earnings and the employer contributing a minimum of 3%.
For example, Tom is earning £30,000 annually. The minimum of qualifying earnings for pension contributions in 2022/23 is £6,240 per year. This means that pension contributions are made based on his earnings above £6,240.
- In a year, £23,760 (£30,000 – £6,240 = £23,760) are Tom’s qualifying earnings for pension contribution.
- He pays 5% of his qualified earnings to his pension – specifically, he pays 4% himself and 1% is tax relief from the Government. Therefore, £1,188 (£23,760 – 5%) of pension contributions go into his pension annually or £99 monthly.
- Tom’s employer pays 3% of his qualified earnings to his pension. Therefore, £713 (£23,760 – 3%) of contributions go into Tom’s pension annually from his employer, or £60 per month.
Once contributions are made to your pension, these funds are being invested for the employee with a potential for the pot to grow.
Employees and employers don’t pay tax on pension contributions. Instead, the Government offers tax relief in the form of a pension top-up for those who save into a workplace pension. If the employee is a basic earner, tax relief is equivalent to 20%, and if they’re a high earner then tax relief is 40% or 45%
In Tom’s case, he is a basic earner, which means tax relief on his pension contributions is equivalent to 20%.
- Tom’s monthly contributions to his pension are £100 every month, but it costs him £80 (£100 – 20% = £80) because £20 is the Government’s top-up as tax relief.
There’s also an annual pension allowance, which is the most an employee can save into their pension without paying tax and within a financial year. Annual allowance allows employees to save £40,000 within a financial year to their pension and receive tax relief. However, if they exceed £40,000, they will have to pay tax on contributions above this amount.
A private pension such as a defined contribution one is accessible at 55 and over. It will increase to 57 in 2028.
Many choose to defer and withdraw their pension later in life, leaving their savings invested and continuing to contribute into their pot.
Withdraw a pension
There are three main options when withdrawing a pension:
- receive it as monthly income
- purchase an annuity with the pension savings
- cash in the whole pot or withdraw several lump sums.
A 25% lump sum is tax-free whether the employee chooses to cash in the whole pot or take out several ones.
- a pot is worth £100,000. By cashing in the whole pot, £25,000 (25% of the pot) is tax-free, while the rest £75,000 will be taxed at the employee’s marginal tax rate.
- A pot is worth £100,000 and they choose to receive their pension in several lump sums. They choose to receive £1,000 a month as a lump sum, which means that £250 of each lump sum will be tax-free and the rest taxed based on the employee’s marginal rate.
Income drawdown is the most common option when it comes to withdrawing a pension. When employees agree on income drawdown, they agree to receive a monthly income from their savings while leaving the rest invested, until the pot runs out.
Lastly, they can purchase an annuity with their pension savings. An annuity is a financial product from an insurance company that guarantees an income for the rest of your retirement and lifetime.
An employee should check with their pension provider on how to withdraw their pension, as each pension scheme has different withdrawal options.
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