Updated 25 July 2017
Let’s face it, pensions aren’t cool. Actually they’re red hot. You’d have to search very hard to find any investment that’s even half as rewarding as the average pension. And the secret’s in the pension Fire Triangle.
Who remembers school science lessons? Come on, you’re not that old. In fact the younger you are, the more money you’re going to make by reading on.
In science we learned about something called the fire triangle. It shows the three ingredients you need to set something alight. These are heat, oxygen, and fuel (something to burn). Like so:
Well, a similar process goes on when you save into a pension. The pension triangle looks like this:
Enough with the diagrams!
Okay, sorry. Many people don’t fully appreciate their pension, because they don’t grasp how the triangle works. But it’s quite simple. Your contributions are the money you pay in each month, while compound interest is how much the pension pot grows year by year. Compound interest is particularly exciting, because the larger your pot grows, the faster it gains value – like a fire spreading (but in a good way).
But if contributions are the fuel, and compound interest is the heat, then the oxygen of your pension is tax relief.
Why tax relief is such a big deal
Tax relief is probably the most misunderstood (and underestimated) part of pensions. Some people think it refers to the interest being paid free of tax, like in an ISA. The interest certainly is paid free of tax, but that’s not tax relief. What it actually means is a lot of extra money.
Take Esme. She pays £100 a month into her pension. But when she checks the balance after the first month, she finds £125 in there. This is because money paid into your pension is not taxed like your other income. Esme pays tax at 20 per cent, and £125 taxed at 20 per cent would be £100. So when she pays £100 into her pension, it turns back into £125 (all of which is going to earn compound interest).
Sally’s pension is even more interesting. She’s a higher rate taxpayer, so she normally pays tax at 40 per cent on her top slice of earnings. When she pays £100 into her pension, she ends up with just over £166 pounds – the amount that would be reduced to £100 if taxed at 40 per cent.
The simple way to think of tax relief is as an additional contribution from the government, whenever you pay in yourself. It’s like the oxygen pumped into your pension which makes it such a red-hot investment.
You’re even better off in a workplace pension, because then your employer also contributes – making a fire tetrahedron! (All you science graduates can stop writing in now). You’re not likely to find any investment to beat that.
Of course you can’t access your pension pot until you’re 55, but you can see that as just another advantage – it’s to ensure you still have plenty of funds to keep you warm in retirement. So if you’re not currently saving as much as you can into your pension, it’s time to wake up and smell the tax relief. Come on – it’s not rocket science.
Is your pension as hot as it could be? Find out by booking a free pension check today.
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