I had some time on the weekend to consider the best approach to my pension contributions. I found myself going down a rabbit warren of spreadsheets and tax legislation and thought it might be an idea to share what I found.
What are pensions?
Pension is a term used to describe money which is protected from tax and is intended for retirement. Currently, you may only access your pension funds once you reach 55 years old. Other features include:
- Mandatory enrolment for all employees who are eligible.
- Tax-free contributions are limited to £40,000 per year.
- Max limit of £1,030,000 total lifetime contributions per person. (note: this is likely to increase with inflation each year).
For more info on pensions in the U.K.; click here.
ISAs are slightly different investment vehicles which are protected from tax but limited to contributions of £20,000 per year. You will not pay tax on any gains on money in the ISA. You may have cash, help to buy or stocks and shares ISAs. Some more info on ISAs can be found here.
I have roughly £100k in pension already. So I’m not starting from scratch. After reading a few FIRE blogs that recommend maxing out the pension contributions I built a spreadsheet which allowed me to play around with figures and % of my salary contributions.
Working on the basis that to get the maximum tax efficiency, I should put in all my income above £50,000 which is the level where I pay 40% tax. I would contribute £2533 per month and my employer would contribute £333 per month and it means I could stash away quite a lot very quickly.
Great I thought, let us do it. Then I realised two big problems.
- I can’t touch this money until I am 55 (likely to be 57 by the time I get there).
- There is a limit of £1030,000 in the pension overall across all funds. [update: it will be about £1.5m by the time I’m 57, assuming inflation rises, but that is not guaranteed).
Combined it means I have 21 years until I can touch that money again. It also has 21 years of compound interest growth meaning if I keep contributing to it at that rate, it will vastly exceed £1,030,000, attracting taxes of 45% on withdrawal by the time I get to 57. Not only was it surprising to see how achievable getting to £1m was by age 57, but it was also even more galling that I am having to look at ramping back my pension contributions to prevent investing in a tax-inefficient way.
I worked back to find out the point that if I maxed out my contribution when I should STOP investing. It turned out, based on a 7% annual increase, I would need to invest until I was 41 and then stop completely. The amount left there would grow to £1m by the time I reach 57 and I would not lose money to tax. Although as I will be working and likely contributing to a pension mandatorily, I would have to opt-out and not take up what is effectively free money. It would be foolish to forego that money at a later date. Yes, I understand that if I achieve FI, I won’t need to work but let us not kid myself here, things change and I will be doing something.
Alternatively, I worked out the monthly contribution that I could make until I hit 55 and working back I would pay £1200 pcm to reach the limit by 55. What I should probably do is have a target age for FI, work out the time and the amount I need to contribute to hit the £1m lifetime limit. At this point, I don’t know what age that would be and I am going to assume that I probably won’t really give up working simply because I am FI.
I have seen various FIRE bloggers talk about bridging to my pension. Bridging is where you have a pension pot you cannot access until the legal age but use up other funds to get you to the point you can use your pension. I am not convinced by this approach mainly because some of their ideas of achieving this would actually reduce financial independence (remortgage of house and drain resources until you reach pension age). All the time your pension is potentially being hammered by the punitive effect of the 45% tax above the lifetime allowance.
The other issue I have is that on a spreadsheet maxing out my savings like that that is fine, but things like life, family, wanting to buy a bigger home at some point, and actually achieving FI at a young age require money to be available to me at some point before I am 57. Doing these sums has had the unexpected effect of focusing my attention on future life goals and how to achieve them.
I want to be FI but I know that things in life change and what will work now may not work later on in life.
To conclude, for now I am going to contribute 15% of my salary to the pension and in addition, my employer will contribute 5%. I will also put £1666 pcm into my S+S ISA. Any extra (which I think is potentially about £1000pcm) will be saved or invested outside a tax-free umbrella and could make a contribution to a deposit for my next home. I believe that having money outside my pension and maxing out my ISA allowance I will put myself on a better path to FI at an earlier age. It will mean I have a boost from my pension later in life to really live it up! I may also investigate paying off my mortgage, but, as previously discussed, I believe this may not be the most efficient use considering the low-interest rate I am paying presently.
I would welcome any further discussion or advice!