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How does contracting out work?

If you choose to contract out by joining your employer's 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.

However, some people continue to build up a small entitlement to the additional State Pension as well. A person contributing to a contracted-out personal pension earning less than £13,900 in 2009/10 in a tax year will also get an additional State Pension top-up for that year.

Contracting out to a stakeholder or personal pension

You can also contract out with a stakeholder pension or a personal pension. If you do this, you will not pay lower National Insurance contributions. Instead, 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 the 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. 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 £78 (based on the tax year 2009/10)
• 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 2009/10)
  

Contracting out to a ‘rebate only’ scheme

Some occupational schemes and 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, you need to bear in mind that the pension you get is based on how well your funds have been invested. The amount of pension you get may not be the same as the additional State Pension you would have received had you remained in the state system (not contracted out). You may need to think about whether this will be enough to support the lifestyle you want when you retire.

Changes to contracted out pensions from 2012

The rules for contracting out of the additional State Pension will change in 2012. The changes mean that contracting out will not be possible through:

• a money-purchase (defined-contribution) occupational pension scheme
• 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
• no longer be able to benefit from any rebate of National Insurance contributions

Contracting out through an occupational salary-related (defined-benefit) scheme will still be allowed. However, contracting out for these schemes will be reviewed in the future.

• The Pension Service

More useful links

• Understanding the additional State Pension