A responsible employer knows the importance of enrolling their employees into a pension scheme that will most likely benefit them during their retirement years. In the same way as any intelligent employee knows the benefits of having a pension plan—Workplace Pension scheme to be exact.
Under the workplace pension scheme regulations, employers who have at least one or more workers have the obligation to provide a pension plan. For tax purposes, even a self-employed individual is considered a worker who works under a personal service contract.
However, the rule of workplace pension scheme may not be applied for individuals managing their own businesses because they might have used the money to other investments like real estate businesses and others. The only thing they need to do is not to work under the contract of service.
Workplace pension scheme is seen as a better option over state pension because of its higher contribution limit—this makes you more financially stable when the time comes.
What is a Workplace pension scheme?
It is a type of personal pension where an employee and/or employer make a regular payment together with the fund invested by the pension provider until retirement age. The fund in your workplace pension scheme is composed of your contribution, your employer’s contribution and the UK government’s contribution in a form of a tax relief.
By 2018, every UK employee gets to have their membership to workplace pension scheme because of an auto-enrolment system. This means that your employer has an obligation to enroll you into the pension scheme. This is designed to ensure that everyone has stored money for their future. But of course, anyone can opt out of this scheme.
Tax benefits of Workplace pension scheme
One of the tax advantages of this type of pension is the government’s contribution, or popularly called tax relief. It means that some of the money that is supposed to be paid in the government as your income tax is put into your pension instead. The two common forms of tax relief paid into workplace pension scheme are:
- Net pay arrangement – the income tax you pay is lowered because you pay tax based on the amount left after taking out your contribution and the government’s contribution from your income. As a rule, you do not have tax relief if you do not pay your tax. This means that there will be no government contribution to your pension as well.
- Relief at source – your contribution is taken out of your salary after you pay your taxes. Afterwards, your pension provider claims it back from the government base on 20% rate. This will then be added to your pension.
A basic tax payer will automatically avail of tax relief. For instance, your pension contribution pay slip has a total of £100. This means that as a basic tax payer (20% rate), your contribution is equal to £80 and the remaining £20 is the government’s contribution. Meanwhile, higher rate tax payer gets only full advantage of tax relief if they claim it upon filing their annual income tax return. And lower rate tax payer gets tax relief for the first £3700 put into your pension contribution. Take note that you can maximize your tax relief based on your earnings as long as you do reach the age of 75.
Is there a limit in your tax relief? Yes, there is. Certain amount of tax is imposed if you have exceeded the contribution limit set in a year. The excess amount is called annual allowance. Hence, if the contribution limit is £50000 and you have £55000, this means that you have an annual allowance of £5000 that is subject to tax.
Another important tax advantage of workplace pension is a tax-free investment. This means that all investments and fund accumulation within your workplace pension is free of tax although some exceptions must also be adhered to. In general, you can get a lump sum of free-tax fund only when you reach your retirement age.
What you have to do to take full-advantage of what the government can offer is to start your contribution as early as possible, gradually increase your contributions (pay rise trick), and consider your employer’s contribution.
How is your money managed in a workplace pension scheme? Technically, there is a third party involved in money management. This third party decides the type of investment option that is right for you. Nevertheless, as a contributor, you can tell them the type of risk that you can take. But unlike other pension schemes, there is no particular type of investment set. So you can engage in any type of business, use bonds, or even enter the stock market.
There are three types of workplace pension schemes: Defined contribution pension schemes and defined benefit pension schemes.
A defined contribution scheme is when your employer chose a pension provider to pay for your pension. The amount of money depends on how much you have paid, how long you paid, and the investment option taken. Obviously, a small portion of your pension is taken as management fee.
The second type is also called final salary or salary-related pensions. In here, the employer sets a certain amount that they will be paying for you during retirement. Like a defined contribution, your salary and time you worked under your employer determines the amount you will receive, regardless of the investments made.
Whichever type of workplace pension scheme you have, the law says that a minimum percentage of your ‘qualifying earnings’ is put into your pension - that is, your whole or your pre-tax salary. At the end of the day, you get your tax back through your pension fund while majority of investments with your money is free of tax.