How Do Pensions Work? UK Pension Guide

Learn how pensions work in the UK, including State, Workplace, and Personal pensions. Find out about contributions, withdrawals, and tax benefits.

A pension is a long-term savings plan designed to provide income in retirement. It allows individuals to save money while working, often with tax relief and employer contributions, to build a secure financial future.

There are different types of pensions, each with their own rules about contributions, withdrawals, and benefits. Understanding how pensions work can help you maximise your retirement income and avoid financial shortfalls in later life.

Types of Pensions

Pensions in the UK fall into three main categories:

  1. State Pension – Paid by the government to eligible individuals who have made National Insurance contributions.

  2. Workplace Pensions – Provided by employers, often with employer contributions.

  3. Personal Pensions – Private pensions, including Self-Invested Personal Pensions (SIPPs), that individuals set up themselves.

Each type of pension operates differently in terms of who pays into it, how much you receive, and when you can access it.

How Does the State Pension Work?

The State Pension is a government-provided pension paid to individuals who have made sufficient National Insurance (NI) contributions.

Eligibility

  • You must have at least 10 qualifying years of NI contributions to receive any State Pension.

  • To receive the full new State Pension (£203.85 per week as of 2023/24), you need 35 years of NI contributions.

  • The State Pension age is currently 66, rising to 67 by 2028 and 68 in future years.

How to Claim the State Pension

  • It does not start automatically—you must apply when you reach State Pension age.

  • Applications can be made through Gov.uk, by phone, or by post.

State Pension Increases

  • The State Pension rises each year based on the triple lock system, increasing by the highest of:

    • Inflation (Consumer Price Index).

    • Average earnings growth.

    • 2.5% minimum increase.

How Do Workplace Pensions Work?

Workplace pensions are set up by employers and are a legal requirement under auto-enrolment rules.

How Contributions Work

  • Employees contribute 5% of their salary, including tax relief.

  • Employers contribute at least 3%.

  • Total minimum contribution is 8% of qualifying earnings.

Types of Workplace Pensions

  1. Defined Contribution (DC) Pensions – The amount you receive depends on how much you contribute and how well investments perform.

  2. Defined Benefit (DB) Pensions – Also known as final salary pensions, these provide a guaranteed income for life, based on salary and years of service.

When Can You Access a Workplace Pension?

  • You can withdraw your workplace pension from age 55 (rising to 57 in 2028).

  • Options include taking a tax-free lump sum, pension drawdown, or buying an annuity.

How Do Personal Pensions Work?

A personal pension is a retirement savings plan that individuals set up themselves, independent of an employer.

Types of Personal Pensions

  • Stakeholder Pensions – Low-cost and flexible pension options.

  • Self-Invested Personal Pensions (SIPPs) – Allow greater investment choice, including stocks, funds, and property.

Tax Benefits

  • You receive 20% tax relief automatically on contributions.

  • Higher and additional-rate taxpayers can claim 40%-45% relief via self-assessment.

How Do Pension Withdrawals Work?

Once you reach 55 (rising to 57 in 2028), you can start withdrawing from a workplace or personal pension.

Withdrawal Options

  1. Tax-Free Lump Sum – You can take 25% of your pension pot tax-free.

  2. Pension Drawdown – Leave funds invested while withdrawing money when needed.

  3. Annuity Purchase – Buy an annuity for a guaranteed regular income for life.

  4. Full Pension Withdrawal – Withdraw all funds at once (but be mindful of tax implications).

Tax on Pension Withdrawals

  • The first 25% is tax-free.

  • The remaining 75% is taxed as income, meaning large withdrawals could push you into a higher tax bracket.

What Happens to a Pension When You Die?

  • State Pension stops when you die, but a spouse may inherit a portion.

  • Workplace & Personal Pensions can be passed on to beneficiaries.

  • If you die before age 75, your pension is paid tax-free to beneficiaries.

  • If you die after age 75, beneficiaries pay income tax on withdrawals.

Final Thoughts

Pensions are a tax-efficient way to save for retirement, with State, Workplace, and Personal pensions providing financial security. Understanding contribution limits, withdrawal rules, and tax implications can help maximise your retirement savings.

If you are unsure how to manage your pension, seeking advice from a financial adviser can help you make the most of your retirement planning.