Monday, February 20, 2012

The Basics of a Pension Plan - Tax Benefits and Pension Lump Sums

By Kate Woods

The media is keen on reminding us that an inpoverished old age waits for those of us who haven't saved for retirement. We are constantly being persuaded to sort out our pension planning. But how many of us actually understand what a pension is?

Fundamentally, a pension is a long term savings plan whose one purpose is to give you a dependable income once you retire. You put away a little of your income once a month month through your working life and by the time you retire, this will have matured into a tidy sum. That sum is then switched to an annuity which pays you a set amount of income which should support you for the rest of your life.

This might be reason enough for the majority to get a pension anyway, but the government believes we need more support to take responsibility for our future. They therefore consent to refund back at least some of the tax you paid on the cash you choose to invest.

What does this mean? Well, if you pay the existing basic rate of tax (20%), then if we ignore national insurance for a moment, for every £100 you earn, you take home just £80. However , if you put that £80 into a pension, the government give you back the other £20 so you get the full £100 invested. If you are a higher rate taxpayer (paying 40% tax), subject to maximum limits, you get £100 invested for laying out only £60.

While considering tax benefits regarding pensions, what's worth discussing is that when you reach age 55, you are entitled to take as much as 25% of your complete allowance amount entirely tax free (though this will impact on your potential earnings in retirement). Taking an early pension lump sum such as this will definitely see you on you way to that well overdue vacation and is undeniably an incentive to start saving toward retirement.

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