By John Lawson
Savers have a lot of choice when deciding where to invest extra pension savings. If you are employed, one of those choices will be your workplace pension scheme.
There are pros and cons to putting your excess pension savings in your workplace pension rather than taking out your own individual pension.
Advantages of paying excess contributions into a workplace pension
- Charges for the default fund in workplace pensions cannot exceed 0.75% by law. Default funds must be made available for people who don’t make an investment choice. In many cases employers will negotiate even lower charges and it is not unusual for workplace pension schemes to have total charges of 0.4% or less when investing in the default fund.
However, to get the low charge you usually must invest your savings in the default fund or a limited range of other fund choices. If none of these meet your investment needs, then the low charge is effectively worthless.
It is also possible to keep your charges low on your own individual pension if you invest in tracker funds which track indices such as the FTSE All Share (tracks UK shares), MSCI World Index (tracks worldwide shares) or the All Stocks index (tracks UK government bonds). If you choose tracker funds, expect to pay no more than a total of 0.5% in total for an individual pension. If you want the benefit of some investment management expertise, then a multi-asset fund can be a cheap way to invest; expect to pay total charges of 0.75% or less for an individual pension invested in a multi-asset fund.
- Your employer may allow you to pay excess contributions via salary sacrifice – also called ‘salary exchange’ or ‘bonus sacrifice’.
Salary sacrifice entails giving up part of your salary in exchange for an extra payment into your pension from your employer.
By giving up the top slice of your income, you have effectively received income tax relief at your highest rate. Salary sacrifice also reduces the National Insurance contributions you pay by 12% of the amount of salary that you have given up if your income is between £8,424 (£8,632 from 6 April 2019) and £46,350 (£50,000 from 6 April 2019) a year. If your income is above £46,350 (£50,000 from 6 April 2019) your National Insurance contributions are reduced by 2% of the amount of income given up.
Your employer also saves on employer’s National Insurance contributions. Some employers retain this to cover the costs of administration for the salary sacrifice arrangement, while others share the savings they make with employees by paying in even more into their pensions.
Salary sacrifice is the most efficient way for most employees to receive tax relief because you automatically get income tax relief at your highest marginal rate, and you pay reduced National Insurance contributions.
However, before you enter into a salary sacrifice arrangement with your employer, there are a number of points you should consider:
- Salary sacrifice doesn’t work well for people who pay no tax. If, for example, you earn less than the personal allowance of £11,850 (£12,500 from 6 April 2019), or your salary sacrifice takes you below that level. Because you don’t pay tax in the first place you won’t reduce the tax you pay by reducing your salary. People in this situation should pay any excess pension contributions after tax income into a personal pension where you will get 20% tax relief added, even though you pay no income tax.
- You are required to contractually agree to reduce the income you receive. Some people may not want to agree to do this.
- A reduced income could have implications for your state benefits. This could be favourable or unfavourable. For example, reducing your income may increase the amount of child tax credit or child benefit you receive. However, if your income reduces below the lower earnings limit (£6,032 in 2018/19) you could lose entitlement to benefits such as state pension and statutory maternity pay. Check the overall impact of salary sacrifice, particularly on your entitlement to state benefits before you agree to go ahead.
- A reduced income could affect the amount you are allowed to borrow. Most lenders will take into account your salary before the sacrifice took place, when calculating the amount you are allowed to borrow, but some lenders don’t.
- Salary sacrifice is optional, so you don’t have to agree to make your pension payments this way.
Advantages of paying excess contributions into your own personal pension
As an alternative to paying extra pension contributions into your workplace pension, you could take out your own personal pension or self-invested personal pension (SIPP). This could offer a number of advantages:
- Individual personal pensions and SIPPs generally offer a much wider investment choice than workplace pensions. This might be a valuable feature if you are a more knowledgeable investor and want to choose investments from a wide range rather than a narrower range usually available via workplace pensions.
- Individual personal pensions and SIPPs are more likely to offer a wide range of withdrawal options that allow you to make full use of pension freedoms, for example, the ability to take ad-hoc lump from your pension fund. Workplace schemes may restrict the retirement options available and, in some cases, force you to transfer to another pension at retirement.
- Contributions paid into personal pensions and SIPPs from your own money qualify for immediate tax relief of 20%. If you are a non-taxpayer and pay money into your workplace pension you might not get any tax relief at all if the scheme is an occupational pension and deducts contributions from your gross pay. Also if your employer asks you to use salary sacrifice to pay extra pension contributions, you may miss out on tax relief if your income is too low for you to pay any tax on.
- We all collect different pensions as we move from employer to employer. Having your own personal pension or SIPP allows you to transfer all of these into one place. There are pros and cons to consolidating pensions; make sure you take extra care when transferring. Existing pensions that contain guarantees or which are invested in with profits funds, and consider taking advice if unsure.