Auto enrolment – thinking of opting out? Make sure you understand what you could be losing out on
If you have been put into a workplace pension under the auto enrolment programme, you may have had to pay more into your pension pot from 6 April 2018, which might mean you will be taking home less pay. If you are on a low income and are considering opting out, then that is understandable, but you should make sure you understand the longer term consequences, so you can make an informed decision as to whether opting out is the right thing to do. Here we tell you more.
Auto enrolment is a Government programme which means you may be put into a workplace pension scheme automatically. This is to help you build a private pension that you can use in retirement, over and above the state pension. You can read about auto enrolment on our website.
Remember that the state pension is only worth around £8,500 a year at current rates, provided you have a 35 year National Insurance contribution record. It kicks in at age 65 for both men and women from October this year, rising to 66 in 2020 and 67 in 2028. Further rises to state pension age are forecast.
Until now, staying in the workplace pension scheme you have been put in by your employer, has been a fairly easy choice – the contribution rates have been low and opting out would mean losing free money from your employer, and potentially the Government.
The recent increase in contribution rates under the auto enrolment programme however, makes auto enrolment a much bigger consideration for workers on lower incomes. Indeed, many such workers may be thinking about opting out, particularly as the contribution rates are going to rise again in April 2019:
|Overall total contribution required||Minimum from employer||Potential contribution from you|
|Up to April 2018||2%||1%||1%|
|From April 2019||8%||3%||5%|
But, if you can afford it, pension saving can be a good idea. Here we briefly outline some of the main benefits from a tax perspective of pension saving for those on low incomes (based on current law, although please note that tax benefits may depend on individual circumstances and may change in the future).
When you are saving into a pension
When you contribute into a workplace pension, you will usually get some tax relief to help make up your contribution – so the actual cost to you will be less than you think.
If the pension scheme uses a ‘relief at source’ method of tax relief (as most do) then the scheme provider is able to claim 20p in tax relief from the government on every 80p you pay in, regardless of how much you earn (this will be paid directly by the Government into your pension pot). The tax relief therefore turns the percentages noted in the last column in the table above to:
|Potential contribution from you|
Petro (and his employer) pay pension contributions each month based on his salary of £1,500. In 2018/19, the first £503 of this pay is not counted, so they each have to pay contributions based on £997 each month. Petro needs to contribute 3% of this amount, assuming his employer pays the minimum contribution of 2%. The contribution Petro needs to pay is £29.91 per month. But the Government pays part of that by giving him 20% tax relief on the amount he pays (£5.98). The actual cost to him is £23.93, but the full £29.91 goes into his pension pot, together with the sum paid by his employer, another £19.94 (which is also tax free).
Some other providers use a different approach, (‘net pay arrangements’) which means that the pension amount is deducted BEFORE tax is calculated (meaning the employee receives tax relief there and then). However, this means that employees do not get any tax relief to help make up their contribution unless their earnings are more than £11,850 (in 2018/19).
Many people think this is unfair as people in relief at source schemes still get tax relief if their earnings are under £11,850 and there are growing calls for the Government to change the rules. In the meantime it may be useful for those on the lowest incomes to know that even if you can’t get tax relief, if you get certain means-tested benefits like Universal Credit, qualifying pension contributions can reduce the amount of income that is taken into account in assessing the award, meaning you may get a higher benefit award if you make pension contributions.
While your money is in the pension
The money that you contribute into your pension pot will be invested by the pension company. Any returns that are made by the pension company are further invested, so that returns are earned on top of returns from that moment on. This is known as ‘compounding’ and it works like this:
Let’s assume that you have £100 to put into your pension on 1 January. Over the course of the year, it grows by 5%, so on 31 December your pension pot is worth £105. If the pension pot grows by 5% in the next year, you would have £110.25 (rather than just £110). Not only did you earn money on your original £100 in year two, you earned money on year one’s growth.
There are never any guarantees, but because compound interest is one of the most fundamental ways to build a pot of money, usually your pension pot will be expected to grow over time, even after allowing for inflation and pension scheme charges. There is no income tax or capital gains tax to pay each year on any growth within the pension pot.
Continuing the example of Petro above (who is age 25), every month from April 2018, £49.85 goes into Petro’s pension pot. At the end of the tax year, this will be £598.20 (in fact, it will probably be more because there will be monthly growth which is compounded, but we will keep it simple for the purposes of this illustration). Even if Petro makes no further contributions to this pension pot, by the time he reaches 55 (the current age that he can normally access his pension pot), assuming it grows at a rate of 5% a year, Petro’s pension pot will be worth around £2,600.
The ‘growth’ of £2,001.80 (i.e. the £2,600 less £598.20) is tax free for Petro (although there may be tax to pay when money is taken out of a pension pot – see below). Most of this growth is due to the power of compound interest – the more he pays in to his pension, the more potential there is for him to benefit from it, and if he starts early to take full advantage of compound interest then all the better! It is also worth noting that Petro doesn’t have to take his pension pot at age 55 – he could leave it untouched until he is older and let it grow further.
When you retire
The amount of money you will have in your pension pot when you retire depends on how much has been paid in and how well the investments made by the pension schemes have performed.
At the moment and generally speaking, you have complete freedom to do what you want with your pension pot at 55 (but note that it is proposed that this age will rise to stay at 10 years behind state pension age). This can include, giving the money up in exchange for a set monthly income (an ‘annuity’), treating your pension pot like a savings account and drawing out the money in stages, or taking the whole thing out in a lump sum!
Although pensions are taxed as income when you take them, 25% can be taken tax free. After this, the rest is taxed as if it were salary at the appropriate rate (for most people, this will be at 20%). However because in retirement you may not have much other income and may have some spare capacity in your tax free personal allowance, it is possible, if you take out your pension in stages and spread over a number of tax years, to avoid paying too much tax.
Petro is now 70 and has retired. Petro continued to contribute to his pension throughout his career and his pension pot is now worth £80,000. £60,000 of it would be taxable after taking out 25% tax free cash. If this £60,000 is taken out over 10 years, for example, and Petro has little other taxable income in those years (please note that the state pension is taxable income), he might pay no tax at all (with the standard personal tax allowance set at £11,850 for 2018/19, and with this possibly to increase in future tax years).
We provide more information on accessing your pension on our website, but we cannot stress how important it is to seek some advice before deciding what to do with your pension pot upon retirement. Taking out your pension will not just have tax consequences but can also impact on your or your family’s entitlement to state benefits both in the short and the longer term.
This is just a whistle-stop tour of some of the tax benefits of pension saving (we can only cover so much in a short article), but we hope that this has been helpful in understanding what might happen if you opt-out. There may be wider considerations too, such as how your pension scheme will provide for your dependants if you were to die, and you should check your individual position with your pension scheme provider.
Of course, we recognise that those on constrained incomes may really not have a choice about whether to opt out or not, and you can read about some of the reasons you may wish to opt out from your pension scheme, e.g. if you have debt, on the website of the Money Advice Service.