It is often difficult to decide what to do with the little amount of money you have available to save.
Here are some good reasons why you would choose a pension rather than other forms of saving:
Most medium and large employers in UK offer a pension scheme where they will pay money into your pension pot.
Often, the more you pay in, the more they will pay in.
Since this is effectively free money you should therefore look to increase your level of contributions up to the level that maximises your employers’ contributions.
Remember, if you delay, you have missed out on free money and can’t ever get it back.
A typical employer’s scheme might require you pay a minimum level of contributions to join.
However, if you pay more than the minimum, they will also increase the amount they pay in.
Imagine your employer’s scheme requires you to pay 3% as a minimum and this means the employer also pays 3%.
But if you pay 5%, the employer will also pay 5%.
In this case if you are not already paying 5%, you should aim to pay 5% as soon as you can afford, otherwise you are missing out on free money.
In the above example, assume you earn £20,000 a year. By paying 5% rather than 3%, your extra £400 contributions would mean your employer would pay another £400 as well. So you would immediately double your £400 to £800. And this is before any benefit from tax relief.
Whilst your pension contributions get tax relief, you still incur national insurance before your contribution is paid into a pension scheme.
However, where an employer pays money into a pension scheme on your behalf, national insurance is not payable by you or the employer.
Therefore, if you give up salary equal to the value of your pension contributions, in return your employer then increases the contribution into your pension by the amount of salary you give up so your pension contributions are unaffected overall.
However, your national insurance goes down, so you will be better off.
Further, the employer’s national insurance goes down, and some employers pass some or all of this saving onto the employee making salary sacrifice even more attractive.
There is a small detriment to your state benefits, but this is more than offset by the national insurance savings you make, even if the employer decides to hang onto its own national insurance saving.
Say you earn £20,000 and pay 5% to be in your employer’s scheme, which is £1,000 per year. Let’s ignore whatever level of contributions your employer makes, as these are not relevant.
If you agreed to salary sacrifice, your salary becomes £19,000, but you don’t make any pension contributions yourself. Instead, your employer now pays an extra £1,000 into your pension scheme. As a result, the amount being paid into your pension scheme each year is effectively unchanged, being £1,000.
However, you no longer pay employees’ national insurance on the £1,000, so you save around £120 each year.
Your employer also saves around £138 in national insurance contributions and might pass on some or all of this to you – most likely in the form of extra pension contributions.
So in the best case you would be around £258 a year better off, made up of £120 increase in take-home pay and extra pension contributions of £138 per year, meaning total pension contributions of £1,138 rather than £1,000.
Your earnings are between certain ranges where additional tax might be mitigated (assuming you can afford the extra contributions). For example:
If one or more parents has taxable pay in excess of £50,000 a year, then child benefit start to be reduced.
If earnings exceed £60,000, no child benefit will be payable. (Note child benefit will be paid but you will effectively pay it back via increased tax falling due via your self-assessment tax return).
If you pay extra pension contributions, this reduces your taxable pay, so you would keep more of your child benefit.
Say you earn £55,000 and you have two children that gives you child benefit of £33.70 per week (£20.30 for first child and £13.40 for second child).
As your earn over £50,000, you will give up 50% of your child benefit. So you will lose child benefit of £876.20.
Assuming you can afford the extra contributions, if you paid £5,000 into your pension, you would then keep all your child benefit.
Combined with the tax relief on your pension contributions, your take-home pay will be £3,000 less. However, £5,000 will go into your pension and you will keep an extra £876.20 of child benefit payments.
So your effective tax relief will be over 57%.
For every £2 you earn above £100,000, you lose £1 of your annual tax free allowance.
Assume you earn £110,000,so the earnings between £100,000 and £110,000 are being taxed at 40%, plus you lose £5,000 of your annual tax allowance.
This means you now pay 40% tax on your first £5,000 of income, or extra tax of £2,000.
So the overall tax on earnings between £100,000 and £110,000 is £6,000, or 60%.
Assuming you can afford the extra contributions, if you paid £10,000 into your pension, you would then keep all your personal allowance.
Combined with the tax relief on your pension contributions, your take-home pay will be £4,000 less. However, £10,000 will go into your pension so your effective tax relief will be 60%.