How Do Pensions Work

A clear, detailed guide to how pensions work in the UK, covering contributions, tax relief, retirement options and more.

How Do Pensions Work?

Pensions can feel confusing, especially when you’re trying to plan for something decades away. But at its core, a pension is simply a way of saving for your future, with generous tax advantages and employer support in many cases. Whether you’re employed, self-employed or approaching retirement, understanding how pensions work is essential to making informed decisions about your future income and financial wellbeing.

This guide explains the different types of pensions available in the UK, how contributions and tax relief work, and the rules around accessing your pension. It’s designed to give you the clarity you need—without the jargon or overwhelm.

What is a pension?

A pension is a long-term savings product designed to help you build up money for later life. In return for tying your money up until at least age 55 (rising to 57 in 2028), you receive tax relief on contributions and, in many cases, free money from your employer too.

In the UK, there are three main types of pensions:

  • State Pension – provided by the government based on your National Insurance contributions

  • Workplace Pension – arranged by your employer and usually includes employer contributions

  • Personal Pensions – including SIPPs (Self-Invested Personal Pensions), which are set up by individuals

Each type plays a different role in your retirement plan and may be used in combination.

Who do pensions affect?

Pensions are relevant to nearly everyone:

  • Employees are automatically enrolled into workplace pensions by law if eligible

  • Self-employed people need to set up their own personal pension, such as a SIPP

  • Company directors can benefit from employer contributions via their limited company

  • Retirees use their pension pots to provide income through drawdown, annuities or lump sums

Even if you’re not currently paying into a pension, it’s worth understanding how they work—you may have old pension pots or be entitled to the State Pension.

How pension contributions work

When you pay into a pension, your money is invested, giving it the potential to grow over time. The contributions you make are boosted by tax relief and, in workplace schemes, employer contributions.

Tax relief on personal contributions

The government adds basic-rate tax relief to your pension payments. That means if you pay in £80, the government adds £20—making a total contribution of £100. If you’re a higher-rate or additional-rate taxpayer, you can claim back more through your Self Assessment tax return.

Tax relief is available on contributions up to 100% of your annual earnings (capped at the annual allowance—more on that below).

Employer contributions

If you're in a workplace pension scheme, your employer must pay in at least 3% of your qualifying earnings. You’ll usually pay in 5%, bringing the total to 8%. Some employers are more generous and offer to match higher contributions.

Annual allowance and contribution limits

The annual allowance is the maximum you can contribute to pensions each tax year while still receiving tax relief. For the 2024/25 tax year, this limit is £60,000 across all your pensions. Contributions above this may trigger a tax charge unless you can use the carry forward rule.

Carry forward

If you haven’t used your full annual allowance in the past three years, you may be able to carry forward unused allowances—provided you had a pension in place during those years and you earn enough in the current year to cover the total contribution.

Money Purchase Annual Allowance (MPAA)

If you’ve accessed your pension flexibly (e.g., through drawdown or taking a taxable lump sum), a lower limit called the MPAA may apply. This is currently £10,000 per year.

Lifetime Allowance (LTA) – recent changes

Until April 2023, the Lifetime Allowance capped the total amount you could build up in pensions without extra tax charges. This has now been abolished, although a new cap on the tax-free lump sum (25% of the old LTA, or £268,275) still applies.

Pension tax benefits

Pensions are one of the most tax-efficient ways to save:

  • Tax relief boosts contributions from day one

  • Investment growth within pensions is free from income tax and capital gains tax

  • 25% tax-free lump sum available when you start accessing your pension

  • Tax planning – higher earners can reduce taxable income by making pension contributions

These benefits make pensions especially powerful for long-term wealth building and retirement planning.

Retirement options: How you can take your pension

From age 55 (57 from 2028), you can start accessing your pension pot. Your options include:

  • Lump sums – You can take all or part of your pension as cash (25% tax-free, the rest taxed as income)

  • Flexi-access drawdown – Keep your pension invested and draw income as needed

  • Annuities – Exchange your pension pot for a guaranteed income for life

  • Phased retirement – Access your pension in stages while continuing to work part-time

Choosing how to take your pension depends on your lifestyle, health, other income sources, and whether you want income security or flexibility.

Workplace pensions and auto-enrolment

Under auto-enrolment rules introduced in 2012, employers must enrol eligible employees into a pension scheme and contribute to it. You’re eligible if you:

  • Are aged between 22 and State Pension age

  • Earn at least £10,000 a year

  • Work in the UK

You can opt out if you choose—but doing so means missing out on valuable employer contributions and tax relief.

If you’ve changed jobs multiple times, you may have several old workplace pensions. It’s worth tracking them down using the Pension Tracing Service and considering consolidation to simplify your retirement planning.

When and how you can access your pension

You can usually access your pension from age 55 (rising to 57 from April 2028). This doesn’t mean you have to retire—but it gives you flexibility.

Access options and tax implications vary:

  • The first 25% of your pension is usually tax-free

  • The remainder is taxed as income in the year you receive it

  • Taking large lump sums could push you into a higher tax band

Planning withdrawals carefully can help reduce your overall tax bill and ensure your pension lasts throughout retirement.

Common pension mistakes to avoid

Many people make avoidable errors when dealing with pensions. Some common pitfalls include:

  • Opting out of a workplace pension without understanding the long-term cost

  • Failing to review old pensions and losing track of pots

  • Accessing pensions too early, triggering the MPAA and limiting future contributions

  • Withdrawing too much at once, leading to large tax bills

  • Relying solely on the State Pension, which may not be enough to live on comfortably

Practical steps to improve your pension planning

Taking a few key actions now can boost your retirement income and simplify your finances:

  • Check your State Pension forecast at gov.uk to see what you’re on track to receive

  • Log in to your workplace or personal pension account to check contributions and performance

  • Consider increasing contributions, even by a small amount—especially if your employer will match it

  • Consolidate old pensions if it makes sense for fees, performance and admin

  • Speak to a regulated financial adviser if you’re unsure about investment options or retirement strategy

Pensions are complex, but they don’t have to be intimidating. The earlier you engage with your pension, the more control you’ll have over your future—and the more time your money will have to grow.