What Are Pensions and How Do They Work?

When people hear the word pension, they automatically assume it is for old people.  This is simply not the case at all.  Basically, a pension is a lump sum of cash that either you, the employer you work for or the government puts money into.  The IRS does not touch this money and it is a way of saving for retirement.  Once you hit retirement age, you are able to take money from your pension or you can choose to turn the cash in to an insurance company in exchange for a monthly income until you pass away.  This regular income is known as an annuity.


You should know how your pension will affect your income.  First, you will be happy because you received a pay raise but at the same time, you are losing disposable income.  When your employer contributes money, you also get taxes back on that money.  What this means is that your overall income will increase as additional money is put right back into your pension fund.  While you will not get all that additional cash to use right away, it will be an investment in your future.  When you contribute to your pension, you will have less in your paycheck so be sure that you budget correctly.

When you have a pension, you have the added benefit of a tax relief.  This tax relief comes in two forms.  You will receive some money back on the amount that you have put into your pension fund and the gains that you make from the investments are mainly tax free.  If you are under age 75, you are eligible to get the taxes back that you have paid on your pension fund.  Generally, if the money is personally added to your pension fund or your employer adds money, the government will give you 20% back.

You will not get 20% back of the total amount that you contributed.  Instead, the IRS will figure out how much you earned prior to the tax being deducted.  The amount that you will get back will be the difference between what you contributed and what your earnings were before taxes.

The phrase the more, the merrier holds true for pensions also.  The more money that you are able to contribute, the better off you will be.  There is a general formula that is used to figure out how much you should be contributing to your pension fund.  Take the age that you are when you started your pension fund and cut that number in half.  So if you were 40 when you started, your number would be 20.  This will be transferred into a percentage and that is the amount of pre-tax income you should put into your pension every year until retirement.  So in this case, you would put 20% of your salary into your pension each year.

There are different types of pensions available and the one that you will use will be dictated by your employer.  Each one has a different set of rules and guidelines when it comes to adding money and pension release funds.