Retirement planning

Many people would like to achieve the dream of financial independence and being able to retire early. However, to retire comfortably you need to think about contributing to a pension in order to build up a retirement fund.

What are the benefits of pensions?

Pensions are a great way to build up a nest egg because:

• They provide tax relief on the contributions that you pay in

• You can’t touch the fund until age 55 (although this is rising to 57 in a few years' time), so there is a lot of time for your money to grow, and

• Your employer is frequently required to add to your pension if you have a pension scheme at work – this is effectively extra money

How do I start to save in a pension?

Retirement may seem a long way off but the earlier you start to save, the better. So if you get an opportunity to join a workplace pension scheme, or if you are able to start your own personal pension scheme if you are self-employed, then you are building up money for the future.

If you are in your 20s or 30s, you can make a real difference to your financial security with relatively small initial pension contributions.

How do pensions work?

If you are employed, your employer should offer a pension scheme at work and may contribute to your pension or even match your pension contributions.

Workplace pensions are a great benefit because the cost of running the scheme is covered by your employer. If you have the opportunity choice to join a scheme at work, you should do so. 

If you are self-employed you can still make provision for your financial security by opening a private pension. Although you will not have the extra contributions from your employer, you can still make use of the tax breaks that come with any type of pension.

How do the tax breaks work?

Paying money into a pension has huge tax advantages. Your contributions are tax-free, so if you are a basic rate taxpayer, for every £100 you invest, you only have to actually pay in £80.

If you're a higher rate taxpayer, it's even better - you only have to pay in £60 to get a £100 investment. Most people pay in a set amount each month, although you don't have to with most funds - you can simply pay in what you can afford when you can afford it.

What are the different types of pension?

There are essentially two types of pension, known as defined benefit and defined contribution:

• Defined benefit pensions give you a set amount when you retire, normally a percentage of your final salary. They are run by your employer and, while you may be invited to contribute, most of the money to pay your pension comes from them. They are almost always the best option, so if you are lucky enough to be eligible, then you should snap up the opportunity. Sadly, however, they are being phased out in most organisations.

• Defined contribution pensions are now the most common. Here, you - and sometimes your employer - pay in a set amount each month. This is then invested by the pension fund and when you come to retire, you buy an annuity, which gives you an income for the rest of your life.

Are there any drawbacks to pensions?

Pensions are a long term investment with generous tax relief, but this does mean that they come with some restrictions.

You cannot take back any contributions you have made before you retire - the money you pay in can only be used to pay your pension, so if your circumstances change in the meantime, the money is still locked in.

And secondly, there are no guarantees about how much you will make - the funds are invested in the stock market, which can of course go up and down, so there's a chance you will lose out. But because it's a long term investment, your fund should ride the peaks and troughs of the market to give you steady growth.

When should I start saving into a pension?

There are two key messages when it comes to pensions:

• The earlier you start saving, the better

• But, it is never too late to start your retirement planning

Starting early is a huge advantage - you do not have to save as much each month, because you will be saving for longer and the money you put in early will have more chance to grow. But the tax advantages mean that no matter when you start, you should end up better off.

How much to save is, of course, up to you, and there are a number of online pension calculators that will show you how much you need to pay in to achieve a certain income when you retire.

Are there other ways to save for my retirement?

A personal pension is not the only option for funding your retirement, although you are unlikely to get the same tax benefits from anything else.

In recent years, many people have invested in buy-to-let property, planning for the mortgage to be paid off by retirement and then living off either the rental income or the sale of the property.

Alternatively, you could simply buy shares, or invest in an ISA or use a lifetime ISA and even get some money added on top. Individual Savings Accounts also have tax benefits, in that you don't have to pay any tax on the growth. Both property and ISAs are more flexible, allowing you to take out money if you need to before you reply.

Is it too early to start saving in my twenties?

If you start making small, regular pension contributions as soon as you start work you will have many years to grow a decent sized retirement fund. The sooner you start saving for your retirement, the longer your money has to grow, and the bigger your pension pot will be. While it may seem a long way off to start saving for a pension when you are in your 20s or 30s, you can start with small contributions and increase them when you get a pay rise. 

When you save into a pension the government gives you an incentive in the form of tax relief. This means that you get extra money paid into your pension fund in addition to the contributions you make. Everyone can get tax relief on their pension contributions, up to a certain level.

You can get tax relief up to 100% of your annual earnings, although in practice not many people would be able to make a pension contribution that is equivalent to their total salary.