Updated 03 December 2020
Letâs face it, pensions arenât cool. Actually theyâre red hot. Youâd have to search very hard to find any investment thatâs even half as rewarding as the average pension. And the secretâs in the pension Fire Triangle.
Who remembers school science lessons? Come on, youâre not that old. In fact the younger you are, the more money youâre 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:
Â Enough with the diagrams!
Okay, sorry. Many people donât fully appreciate their pension, because they donât grasp how the triangle works. But itâs 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 â 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 thatâs not tax relief. What it actually means is a lot of extra money.
Take Esme. She pays Â£100 a month into her pension. But when she checks the balance after the first month, she finds Â£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 Â£125 taxed at 20 per cent would be Â£100. So when she pays Â£100 into her pension, it turns back into Â£125 (all of which is going to earn compound interest).
Sallyâs pension is even more interesting. Sheâs a higher rate taxpayer, so she normally pays tax at 40 per cent on her top slice of earnings. When she pays Â£100 into her pension, she ends up with just over Â£166 pounds â the amount that would be reduced to Â£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. Itâs like the oxygen pumped into your pension which makes it such a red-hot investment.
Youâre even better off in a workplace pension, because then your employer also contributes â making a fire tetrahedron! (All you science graduates can stop writing in now). Youâre not likely to find any investment to beat that.
Of course you canât access your pension pot until youâre 55, but you can see that as just another advantage â itâs to ensure you still have plenty of funds to keep you warm in retirement. So if youâre not currently saving as much as you can into your pension, itâs time to wake up and smell the tax relief. Come on â itâs not rocket science.
Is your pension as hot as it could be? Find out by booking a free pension check today.
Yet to start a pension? Youâre losing money every day. Talk to a financial adviser about the best ways to get started.