A simple guide to pensions

From the state pension to personal pots and how much you need to retire comfortably, our guide explains everything you need to know.

A pension is a long-term investment to help you live in comfort in retirement. If you qualify for the government state pension it’s likely to only cover basic living expenses which is why you might want to consider contributing to a personal pension pot too.

Our pensions guide explains how they work and how to achieve the lifestyle you want in retirement.

• State pension, defined contribution and personal pensions explained
• Is my pension taxable and what is pension tax relief?
• What is the pension lifetime allowance?
• When can I withdraw my pension?

Scroll down to watch our quick pension explainer video.

Read more: Do you pay tax on your pension?

What is a pension?

A pension is like a turbo-charged savings account because the money is invested for the long term (usually over many decades) and enjoys tax-free perks.

Most people start contributing into a pension when they start work because their employer automatically enrols them into a scheme. We explain auto-enrolment below.

Workers usually pay into their pension pot (or several pots) throughout their working lives.

This money you contribute into a pension is usually invested in a diverse range of assets, such as stocks and bonds. If you have been auto-enrolled then a fund manager will probably be responsible for managing these investments on your behalf.

The investment returns within pensions are sheltered from dividend, capital gains and income tax. Pensions also enjoy generous tax relief from the government on top.

Once you reach retirement age or stop working, you can access the money in your pension.

If you have saved plenty of money and your investments will have performed well, it should allow you to live comfortably in retirement.

The different types of pension: state pension, defined contribution and personal pensions

There are broadly three types of pension: the state pension, final salary schemes and defined contribution products.

1. The state pension

This is paid to you by the government when you reach state pension age, which is currently 66. The state pension age will increase to 67 by 2028.

 How much state pension will I get?

The full new state pension is £221.20 a week. The basic state pension is £169.50 a week. Our state pension increase guide explains the rises in full.

However, the amount you receive is based on your national insurance record. This is essentially the number of years you worked or received national insurance credits. You can also make voluntary national insurance contributions – our guide explains how many years you need for a full state pension.

You can look at retirement as a kind of meal with several courses.

Think of the state pension as a starter; don’t rely on it or you will still be hungry. Even if you receive the full new state pension, it works out at just £11,502 a year.

The state pension usually increases each year according to what’s known as the triple lock guarantee.

2. The old-fashioned final salary scheme

The defined benefit pension scheme, also known as the final salary scheme, is a bit of a dinosaur.

These workplace pensions promise to pay you a fixed income when you retire, regardless of how the investments within the scheme actually performed.

The retirement income is usually based on:

• The length of time you worked at the company
• Your salary
• Inflation (based on the retail price index)

Final salary schemes are rare these days and are very expensive for companies to run.

They are so generous that you can think of them like all-you-can-eat buffets, with lucky diners tucking into a tremendous feast.

3. Defined contribution pension

If you are invested in a defined contribution scheme, the value of your pot depends on:

• How much you put in
• Your investment returns

This type of pension has overtaken final salary schemes to become the most common type of pension.

This is because most workplace pensions are now defined contribution schemes.

It works like this:

• You pay in some money out of your regular income each month, and your employer makes payments too.
• This is then topped up with tax relief. For basic-rate taxpayers, that means for every £80 you contribute to a pension, the government will add £20. 

Most full-time workers get a company pension when they start a job. This is because most workplace pension are now defined contribution schemes. If you have been auto-enrolled into a workplace pension system, it will be a defined contribution scheme.

If the state pension is the starter, your workplace pension scheme is like a main course. Hopefully, the two combined will fill you up.

Beyond your workplace pension, there are other types of defined contribution schemes:

The stakeholder pension

Stakeholder is another type of defined contribution scheme so you decide how much to pay in and it gets topped up with tax relief.

However, this is a personal pension so there are no contributions from your employer.

When you turn 55 (rising to 57 in 2028) you can access the pot of money.

There is usually a limited choice of where to invest your cash within the pension. Think of it like dessert à la carte, restricted to the choices on the menu from your pension provider.

The DIY pension

This is another type of defined contribution scheme. The DIY model gives you a huge choice of where to invest your money, from investment funds and bonds to gold and even property.

It’s ideal for confident and knowledgeable investors.

This product is often called a self-invested personal pension, or Sipp. Note that there can be a bigger risk with this one as you have to manage the investments yourself.

Our best personal pension guide explains more.

Is my pension taxable and what is pension tax relief?

When you save into a pension scheme, the government gives you back some of the money you would have paid in tax.

It is basically a way of rewarding you for saving for retirement and having a taxable income. This is tax relief – the great perk of pensions.

To summarise:

When you earn money, income tax is deducted by your employer along with national insurance. If you’re self-employed, this will be calculated by the taxman when you do your tax return.

But the government gives some of this income tax back to you when you save money into a workplace or personal pension.

What you get depends on the rate of income tax you pay.

In England:

• Basic-rate taxpayers receive 20% tax relief (so every 80p gives you a 20p top-up)
• Higher-rate taxpayers can claim 40% (every 60p you save gives you 40p on top)
• Additional-rate payers can get 45% (every 55p you save gives you a 45p top-up)

In Scotland:

• Starter-rate taxpayers and basic-rate taxpayers get 20% tax relief
• Intermediate rate taxpayers can claim tax relief of 21%
• Higher-rate taxpayers can claim 41%
• Top-rate taxpayers can claim 46%

There are various ways you receive the tax relief, but it all works out the same in the end. Ask your company HR department if you want to know the nitty-gritty.

If you’re looking to stretch your pension here are four ways to give your pension pot a boost.

Do you pay income tax on a pension?

Your pension is not a bank account where you withdraw money without penalty. After you have taken the first 25% of your pension pot, which is tax-free, you will then have to pay tax on the income from pensions in the same way that you would for any other income.

Once you have reached the personal allowance threshold of £12,570, you can expect to pay the 20% basic income tax rate on everything from £12,571 to £50,270. The higher rate kicks in between £50,271 to £150,000.

If you are still working, or getting an income from buy-to-let, for example, that money will be added together to work out your tax band.

Read more: What is income tax and how much do you pay?

Do you pay national insurance on a pension?

No, you do not have to pay national insurance contributions on income you take from a pension.

As it stands, once you reach state pension age you stop paying national insurance contributions on your earnings if you are still working.

But bear in mind that if your pension income exceeds the personal allowance, which is currently £12,570, you will have to pay income tax at your marginal rate.

How much income tax you pay depends on how much you have withdrawn on top of any other earnings. Find out more about how income tax works and work out what you owe with our income tax calculator.

What is the pension lifetime allowance?

The pension lifetime allowance was introduced in 2006 but, in his 2023 spring budget, the chancellor said that the lifetime allowance would be abolished. This was to encourage older people to work for longer. It was abolished from April 6, 2024. There will be no lifetime allowance charge in the tax year 2023/24.

There is a deadline of April 5, 2025 for those applying for fixed protection 2016 or individual protection 2016.

Our guide to best pension drawdown providers.

Why should I use a pension?

There are three main benefits to pensions:

1. Tax relief

You essentially get free cash with a pension in the form of tax relief from the government.

The rate of tax relief ranges from 20% to 45% depending on how much you earn:

• Basic rate taxpayers get a £20 top-up for every £80 they put into a pension
• Higher rate taxpayers will get a £40 top-up for every £60 they put in
• Additional rate taxpayers get a £45 top-up for every £55 they put in

We talk about tax relief in more detail later on in this guide.

2. Employer contributions

With workplace pension schemes, your boss has to put in at least 3% of your “qualifying earnings” into your pot, but some may choose to contribute more.

For example, if you pay in 5% of your salary as your pension contribution, your employer might match it and pay 5% too.

This is a bit like getting a pay rise, just delayed until your 55th birthday.

You will often join your employer’s pension scheme on an auto-enrolment basis when you start a new job, but you can find out about the specifics by speaking to your employer.

3. Tax-free lump sum

The third perk is that when you are old enough to take money out of your pension, 25% of it is free from income tax. So a quarter of your life savings will be safe from the taxman.

Many people use a lump sum to pay for home improvements or book the holiday of a lifetime.

However, if you withdraw your pension in small chunks then 25% of each chunk will be tax free. This is a great way to make your pension stretch, as we explain in the final chapter of this guide.

We have also rated personal pensions to help you find the best deals for you.

What is auto-enrolment?

Auto-enrolment was introduced in 2012 and phased in gradually over the years.

Now your employer must automatically enrol you into a workplace pension scheme and contribute at least 3% of your salary.

You will be auto-enrolled if you:

• Are aged 22 or over
• Earn at least £10,000 over a tax year

Your employer must also pay into your pension scheme on time and meet the minimum level of contribution requirements.

Your cash is then invested. You can choose the investments, or you can let the pension provider pick an appropriate fund for you.

You can opt out of auto-enrolment but we don’t recommend it because you will be missing out on valuable contributions from your employer. Think of auto-enrolment like a pay rise.

There are proposals to extend auto-enrolment to workers younger. The government said in the review that it would look to lower the age limit from 22 to 18 and remove the lower earnings limits by mid-2020 to encourage more people to save for their retirements.

If you are self-employed, our guide to best pensions for the self-employed may help.

Auto-enrolment has been a successful way of getting millions of people to save into their pension; however, the downside is that many of us end up with lots of pension pots from our various jobs throughout our lives.

If you have lost a pension pot, you can use the government pension tracing service.

Our Should I combine my pensions? quiz can help you work out if it’s worth merging your pension pots together.

What are the pension rules?

There are lots of pension rules to watch out for.

What age can I access my pension?

One of the main rules you need to be aware of is the age when you can start taking money from your pension pot.

Most personal pensions won’t allow you to access your pension funds until you are 55.

The Treasury plans to increase the age people can access pension savings to 57 by 2028. This is to reflect the fact that people are staying in work for longer.

However, confusingly some schemes will continue to give access at 55 provided that age has been written into their rules.

The Treasury had previously suggested giving pension savers a deadline to transfer their funds to a scheme with a protected pension age of 55.

However, in a surprise move the government closed the transfer window overnight. This meant that millions of savers have been blocked from accessing their pension at 55.

What are the pension thresholds?

There are also tax-free limits on how much you can save into a pension.

These include:

• The annual allowance: Each tax year there is a limit on the tax relief you get on pension contributions. For most people the pension annual allowance in 2023/24 is £60,000 (up from £40,000 in the previous tax year). You can carry forward any unused allowance from the previous three tax years. However, if you’re a top earner then your allowance could be tapered (see below).
• 25% tax-free lump sum: When you withdraw money from your nest egg, you can usually take 25% tax free as a lump sum. As it stands you can take up £268,275 tax free (which is 25% of the lifetime allowance of £1,073,100). We talk about the lifetime allowance in more detail in this section. Once you’ve taken 25% tax-free, the rest of your money is subject to income tax. Or you withdraw your pension in small chunks and a quarter of each chunk will benefit from being tax-free.
• The money purchase annual allowance: Once you start taking money from your pension pot, you are restricted to only contributing £10,000 into your pension every year. This limit has gone up from £4,000 in the previous tax year.
• The tapered annual allowance: This affects the top earners in the country. If you earn more than £260,000 a year then your pensions annual allowance falls to £10,000 a year.

When can I withdraw my pension?

The age at which you can access most workplace and personal pensions is 55. This will increase to age 57 in 2028.

But you don’t have to start taking your pension at this point and many people wait until their sixties before withdrawing money.

Bear in mind that state pension age is different to the age you can take money from a personal pension.

The current state pension age is 66 for both men and women.

This is the age at which you can claim the state pension, although you can choose to defer it. The state pension age will rise to:

• 67 between 2026 and 2028
• 68 between 2037 and 2039

Most people choose to retire when they start receiving their state pension, though you could choose to retire earlier.

If you want to retire early, before the age of 55, then you could use this ISA trick.

Can I retire at 55?

Your pension savings are locked up until you are older, normally age 55 (this age will rise to 57 in 2028).

So yes, in theory you could retire at 55 because that’s the age you can access your pension. However, many people decide to carry on working and saving because their pot isn’t large enough to retire on at 55.

Find out more: Guide to pension drawdown.

Can I withdraw my pension before retirement?

You typically can’t take money from your pension before you reach the age of 55 (rising to 57 in 2028).

There are a few instances where you might be able to take it sooner:

1. If you become seriously ill

You might be able to take your pension before 55 if you become unwell. But this will depend on the individual rules of your pension provider and how they define “ill health”.

If this is the case, you may be eligible to take your whole pension pot tax-free.

But only if you’re expected to live for less than a year.

It’s always best to speak to your pension provider on the exact details of your pension scheme if you’re not sure on when you can take it.

2. Protected pension age

You may also be able to take your pension before your 55th birthday if you joined the scheme before 6 April 2006 and it has a “protected pension age”.

You will need to speak to your pension provider if this applies to you.

How much pension will I need to save?

It is a good idea to estimate how much you think you will want in retirement income every year and then work backwards.

Is £18,000 a year enough? Think about your salary now, and the standard of living you would like to have when you finish work.

If you think £18,000 a year is enough, you would need to built up a pension pot of £260,000. This assumes an annual retirement income of about £9,000 a year if you buy an annuity at age 65.

When added to the maximum state pension, this gives more than £19,000 a year as a regular income

To put the £260,000 nest egg in context:

• A 25-year-old would have to save £390 a month to accumulate such a pot by their 65th birthday.
• A 35-year-old with no pension savings would need to start squirrelling away £570 a month
• A 45-year-old would need to salt away £920

Bear in mind that these figures include tax relief, and your employer may also pay in too. They also assume that you get 4.2% annual investment growth on your pension.

If you want a bigger income with £25,000 being paid to you each year from an annuity, you would need to save £700,000. With the state pension on top, you would have an annual income of more than £35,000.

If you are fantasising about a more luxurious retirement, saving the maximum before the taxman starts knocking on your door (which is £1,073,100) would generate £37,700 a year.

There is a big difference between saving £260,000 and £1 million.

Of course, having more money to play with when you stop working sounds the most enticing. But saving more money for later, will mean sacrificing more of your money now.

If you’re struggling to work it out yourself, a financial adviser will be able to help. Kellands* is offering all of our readers a free hour-long session* with one of its independent financial advisers. They can get a good idea of your financial goals, and help you take the first step to achieving them.

How much should a 40 year old have in their pension?

Investment firm AJ Bell* has carried out some research based on the PLSA target figures.

If you are hoping to reach the basic, moderate or comfortable level of retirement, this is how much you will need in your pot now at 40: 

• Basic = £10,700
• Moderate = £93,300
• Comfortable = £205,400

How much should I have in my pension at 50?

By the age of 50 you will be expected to have almost double the amount as in your forties:

• Basic =  £20,800
• Moderate = £181,900
• Comfortable = £400,100

If you are looking at these figures with fear, remember that it is never too late to make the most of your pension pot.

While obviously the best time to start saving is when you are young, as the extra years of contributing can make a huge difference, with dedication you can build up a significant pot even in your 50s.

Here’s a calculation you can use to figure out how much to save: How much should I pay into my pension?

Have a play with a pension calculator. You can put in how much you save today, and it will predict how much you could have when you retire.

Can I take 25% of my pension tax free every year?

No. Once you have withdrawn 25% of your entire pension pot then you can’t take another quarter tax-free.

Once you have withdrawn your 25% tax-free lump sum, you then have six months to begin to take the remaining 75%. You will usually have to pay tax on the remainder.

Your options for the rest of your pension pot include:

• Buying an annuity (this is a financial product that gives you a guaranteed income for life)
• Taking some or all of it as cash
• Investing it to get a regular, adjustable income, otherwise known as “flexi-access drawdown”

You might want to read: Should I go for an annuity or drawdown?

However, you can choose to withdraw money from your pension in chunks so that 25% of every chunk is tax-free. You could do this every year.

Remember you can only access your pension from 55 at the earliest

How to make your pension stretch

If you are old enough to access your pension, you might be wondering how to make it last longer.

Lots of people decide to crystallise their entire pension and take 25% as a tax-free lump sum. If you do this, the remaining 75% is taxed at your marginal rate.

But there is a way of withdrawing your pension to make it last longer:

• Rather than crystallising your entire pot, withdraw small chunks instead (only take as much as you need to live on comfortably)
• A quarter of each small chunk you crystallise will be tax-free and the remaining three quarters will be taxed as your marginal rate
• This method makes your pension stretch further because you are leaving more of it uncrystallised, which allows it to continue to grow without being hit by tax
• This route means that you can keep benefiting from the 25% tax-free lump sum through your entire retirement

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