Contracting out
If you are an employed earner with annual earnings above a certain amount (£4,680 in 2008/09) you cannot leave the basic State Pension. However, you can if you wish, choose to leave the additional State Pension and join a private pension scheme instead. This is called 'contracting out'.
If you choose to contract out by joining your employer's contracted-out occupational pension scheme, both you and your employer will pay lower, reduced rate National Insurance contributions. When you retire, your second pension will come from your employer's scheme and not from the additional State Pension. Although, most people will continue to build up a small entitlement to the additional State Pension as well.
You can also contract out with a stakeholder pension or a personal pension. If you do this, instead of paying lower National Insurance contributions, once a year the Inland Revenue will pay directly into your pension a rebate of your National Insurance contributions. The rebate is intended to provide benefits broadly the same as t he additional State Pension given up.
You can also join a Stakeholder Pension scheme or a personal pension scheme without contracting out of the additional State Pension, but if you do this, you won't get the rebate.
You will usually get tax relief on your contributions to a private pension scheme. With a basic rate of income tax of 20 per cent, every £100 that goes into your pension costs you £80 (based on the tax year 2008/09). If you pay income tax at the higher rate of 40 per cent, every £100 that goes into your pension fund costs you £60 (based on the tax year 2008/09).
Some occupational schemes and some personal pensions are organised on a 'rebate-only' basis. This means that the only money being paid into the scheme is your National Insurance contributions rebate.
If you have chosen this sort of second pension, it will give you roughly the same pension you would get from the additional State Pension. You may still need to think about whether this will be enough to support the lifestyle you want when you retire.
From 6 April 2003 the State Second Pension gives employees earning up to £31,100 (in 2008/09) a better pension than SERPS, whether or not they are contracted out.
Most help goes to those who earn less than £13,500 in 2008/09.
A person contributing to a contracted-out personal pension earning less than £13,500 in 2008/09 in a tax year will also get a State Second Pension top-up for that year. The top-up reflects the more generous additional State Pension provided by State Second Pension.
The Pensions Act 2007 and the Pensions Act (Northern Ireland) 2008
The Pensions Act 2007 and the Pensions Act (Northern Ireland) 2008 provide for the abolition of contracting out on a money-purchase (defined-contribution) basis. The aim is to introduce this change in April 2012 or the end of the Parliament at the latest. Once this takes effect, you will no longer be able to contract out of the State Second Pension through:
- a money-purchase (defined-contribution) occupational pension scheme; or
- a personal pension or a stakeholder pension.
If you are already contracted out through either type of scheme, you will:
- be able to continue to make your own contributions to the scheme;
- be able to continue to benefit from any employer contributions to the scheme; but
- no longer be able to benefit from any rebate of National Insurance contributions.
Contracting out through an occupational salary-related (defined-benefit) scheme will continue to be allowed, but the long-term future of contracting out for these schemes will be reviewed in the future.
Find out more about pensions reform
If you are not sure what is the best choice for you, you may want to get further help. If you want to know more about contracting out, please see Contracted-out pensions - Your guide (PM7)