If you received an unexpected windfall what would you do? Despite placing it in a pension being far down the list for most people, it could be one of the most prudent decisions.
Just one in 20 people receiving £25,000 would choose to put it in a pension, according to research from Lane, Clark & Peacock. Young people, perhaps unsurprisingly, were the most likely to shun pensions. Just 2% of those aged between 18 and 24 would do so; the same portion would choose to gamble it. This compares to the 9% of 45 to 54-year olds that would place it in a pension.
When asked what they would do with £25,000, survey participants said:
- Use it to purchase a property (22%)
- Put it in a Cash Individual Savings Account (ISA) (17%)
- Deposit it in a bank account (12%)
- Spend it on a holiday (10%)
- Invest (7%)
- Add it to a pension (5%)
It’s natural to want to spend some of a windfall on fun, such as a holiday. However, the research finds that, for the most part, people would take steps to improve their financial security.
For those struggling to get on the property ladder, using a £25,000 lump sum to purchase a home may be the right choice while investing can help the money to grow further. But it seems that many are missing the key benefits that a pension could provide. Although locked away until you are able to access the pension, these advantages could mean that the money placed in a pension can mean reaping more in the long term.
Contributions benefit from tax relief
Money placed in a pension may benefit from tax relief. This means the government effectively top-up your contributions, providing an extra boost to retirement savings. The amount you receive will depend on the Income Tax band you’re in. It’s an advantage that means your savings will grow quicker and benefit from an immediate bonus.
There is an annual limit for pension contributions, above this amount you won’t receive tax relief. If your total contributions for the year are likely to exceed this, it may be beneficial to make several deposits over time to maximise the tax relief you receive.
The current annual threshold is 100% of your annual earnings or £40,000, whichever is lower. In some cases, it is possible to carry forward unused allowances from the previous three years.
The money is invested
7% of people state they would invest the money if they received a windfall. Should you want to invest with the long term in mind, a pension can be an effective way to do this.
The money you place in a pension is typically invested, giving you the potential opportunity to grow your contributions. Pension providers will usually offer several different risk related investment portfolios, allowing you to select the one that matches your tolerance to risk.
Investing your money gives you an opportunity to outpace inflation. With interest rates low, the 22% of people that said they would opt for putting the money in a Cash ISA could see their spending power diminish when inflation is considered. There are times when having liquid assets is the best option but if you plan to hold the cash over the medium or long term, investing may be a better choice.
The effects of compounding
If you leave the returns generated from a pension invested, you also benefit from a compounding effect. This is where your returns are invested, going on to generate returns of their own. Over time, the compounding effect helps your money to grow faster. The more money you add to your pension, the better the effects of compounding. This is also true when investing for longer. As many pensions are started decades before they’ll be accessed, you generally have many years to benefit from the compounding effect.
Your pensions value will be dependent on the performance of underlying investments. There will be times when the value decreases. However, when looking at the long term, your pension should rise in value.
Supports long-term financial security
When receiving a windfall, the research suggests that many would opt to use it to improve their financial security. A pension can help you do this in the long term. Many approaching retirement have concerns about the level of income they can expect once they give up work. Taking steps to add lump sums to a pension when possible can help give you peace of mind.
Of course, it’s not as simple as a one-size-fits-all solution. Depositing a lump sum into a pension may be the right option for some, but that doesn’t mean it will be for you. Depending on your priorities and goals, there may be other ways to maximise a windfall.
This is where financial planning can add value. When you work with us, we’ll look at your personal situation and take the time to understand your aspirations. Whether you’ve benefitted from a windfall or simply want to manage your existing assets better, we can help create a bespoke financial plan that suits you. Please contact us to learn more.
Please note: A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.