Retire from 8 to 5 

As highlighted in this post, 401k was the preferred choice of retirement investment while we were in the USA. The primary reason for this was we didn’t qualify for IRAs or Roth IRAs based on our income levels and maxing out 401k was the best we could do to minimize taxes while maximizing retirement income.

Moving to the UK in 2022 has opened up new possibilities for retirement savings and these vehicles seems to be more generous in terms of the thresholds and the general availability to people. There 2 ways we can contribute to our retirement pot

1. Salary Sacrifice / Workplace Pension Schem
2. Self Invested Personal Pension (SIPP)

There is no limit to the amount that can be contributed to the pension. However, there is an annual cap on how much qualifies for tax relief. It was £40,000 from 2016/17 until 2022/23 and since then increased to £60,000 from 2023/24. This a very generous amount considering the median UK salary is £38,000. The high limits seems to be catering to the high net-worth (HNW) individuals. The tax relief limit applies to the total of –

1. Contributions by you
2. Contributions by your employer
3. Contributions from someone else made on your behalf
4. Tax relief added to your pot

If your pension contributions add up to more than this across the year, then you’ll need to pay tax on the amount you’ve gone over. Essentially, you’ll have to give back any tax relief you received on the excess amount.

Salary Sacrifice / Workplace Pension Scheme
This is exactly like what the title says – you are sacrificing a part of your monthly salary and investing it into your pension pot. Salary sacrifice is typically setup by your employer when you commence employment. There is absolutely nothing you need to do apart from deciding what percentage of your pay you plan to contribute monthly. Plus, it is the law! Every employer auto-enrolls their employees into a workplace pension scheme, provided that those employees are between the ages of 22 and state pension age and earn a minimum of £10,000 annually. You need to opt-out if you do not want to be enrolled. And since its more work to get out, when you are already in, it leads to a generally higher enrollment. Hope this becomes the standard across the world.

When you take up this option, the employer withholds the requested percentage from your paycheck and puts money along with their contribution into the tax advantaged pension plan. This reduces your take home pay (effectively lower salary) and hence you, and the employer, will pay lower National Insurance (NI) tax and lower income tax, thereby getting a tax break. While getting a smaller paycheck seems frustrating, trust us and based on our mistakes, it is never too early to start contributing to retirement. Stock markets have historically gone up and when you decide to retire, there will, hopefully, be a big pot of money for you to use.

In the past 2 years, we have seen that the employer contributions to workplace pensions is more generous that what were have been receiving in the USA. Based on our current jobs and job adverts during our job searches, the standard is 1:1 match from the employer up to a maximum of 10%. In the USA, between our experience and those of our friends, the typical company contribution varies between 50% to 100% of your contribution up to 6% of your pay. The company match is definitely better in the UK as compared to the USA.

For example, in the UK if your base salary is £50,000 and you contribute 10% of your salary, your total contribution to your pension pot will be £10,000 (£5,000 + £5,000 from your employer). The same salary in the USA, leveraging the company’s 401k plan will get you an annual contribution of $6,500 ($5,000 of your contribution + $1,500 from company, assuming they match 50% up to 6% of your salary)

Self Invested Personal Pension (SIPP)
SIPP is another avenue to save for retirement and this sits outside the workplace pension plans. This is typically suited for those who are self-employed and don’t have a workplace pension. You can contribute to SIPP in addition to your workplace pension. The limits to SIPP is the same as that workplace pension – up to £60,000 for tax relief. SIPPs are offered by a variety of brokerages such as Vanguard, Fidelity, Hargreaves Lansdown or Interactive Investor to name a few.

The tax relief treatment for SIPP is a little different from that of salary sacrifice. When you contribute, the government automatically gives you 20% basic rate tax-relief automatically. This is true even if you don’t pay tax or a non-earner. For example, if you contribute £100 to a SIPP, the brokerage will automatically claim £25 from the government and add it to your account. Why £25 and not £20 (20% of £100)?? It took us a while to understand this as well. You’ve already paid tax on the £100 you added to your pension. If you hadn’t, your £100 would have been £125 – that’s because £125 taxed at 20% is £100. So, to make up the difference, the government refunds you £25 back into your pension.

If you are on the higher tax brackets, you can claim additional tax relief on your Annual Self Assessment. The higher pension tax relief is at 40% for earnings above £50,270 and you can get up to 45% if you are in the highest tax bracket. The way the tax relief is a bit different in the sense that your taxable income is not reduced by the amount you contribute but the tax bracket is adjusted by the contribution amount. We learnt this the hard way when we filed our Self Assessment and the refund we got was much lower than what anticipated.

Lets look at a sample SIPP higher rate tax relief calculation:
Total income: £120,000
Tax free allowance: £12,500
Taxable income: £107,500
SIPP contribution: £30,000 (You would have got 20% relief when contributing. We are claiming the remaining 20% now)
20% tax bracket limit increases from £25,125 to £55,125
Basic rate tax: £55,125 @ 20% = £11,025
Higher rate tax: £52,375 @ 40% = £20,950
Total tax: £31,975

The downside of SIPP is you don’t get a pre-tax deduction and there is no NI tax relief.

Whether you have access to salary sacrifice or SIPP or both, the most important thing is to start contribution as much as you can and as early as you can. This is a sure path to a faster financial freedom.