Contractors' Questions: Can I pay myself via a pension?

Contractor’s Question: As a 57-year-old, can I pay myself - tax-efficiently - via a pension? How should I do this so that it’s complaint with tax rules?

Expert’s Answer: The introduction of the pension freedoms reforms in April 2015 have opened up an array of possibilities for how our hard-earned pension savings can be spent. Upon reaching the age of 55 we can access our pension pots and immediately take out as little or as much as we like (after tax); for some that fantasy of cruising the Med in their very own Sun-seeker or breezing around St Tropez in a Ferrari may not be beyond the realms of possibilities after all!

I joke of course, but when the changes were originally announced and in the run-up to them being introduced, if you’d believed what was being written in the press at the time, we should now be dealing with an ageing population who are reliant on the State Pension and food banks to survive, because they’ve wasted all their retirement savings on Botox and Cuban Cigars.

So far, nothing quite so apocalyptic has occurred, but you are asking whether, in this new era, it would be possible to pay yourself a sustainable income from pension savings soon after reaching the age of 55.

In theory, there is nothing to stop you, a 57-year-old, from living off of a regular pension income or from using it to supplement employment earnings. However for this strategy to be feasible from such a relatively young age, it would need careful planning, discipline and, as with all financial planning exercises, consideration must be made for the tax implications.

A report recently published by Public Health England stated that, on average, for those reaching the age of 65, a male can expect to live to age 84 and a woman to 86. Therefore, anybody in good health considering using their pensions from a younger age needs to think about how long they will need that income to last and how it will be spread; for example taking a lower amount to begin with and increasing it as they get older.

From a taxation standpoint, taking regular income withdrawals in this manner would have no instant adverse effects, so long as the agreed approach takes account for existing income. Any income taken from a pension fund will be added to existing earned income subject to income tax and is taxed at the pensioner’s marginal rate. This could provide an ideal solution for an individual wishing to reduce their working hours gradually, but maintain a similar level of pre-retirement income at the same time.

Ultimately, the success or failure of such a plan hinges on the affordability to build up a sufficient pension pot before the age of 55. This will depend on each person’s level of disposable income, however, even those in a fortunate enough position to be able to contribute large sums into a pension on a regular basis may struggle, as the lifetime allowance (which determines the maximum value that pension savings for each individual can be valued at during their life without tax implications), will reduce to £1 million in April 2016. This figure will be reduced from the current 2015/16 amount of £1.25 million; it peaked at £1.8 million in 2010.

This may sound like a high figure and an unrealistic expectation for the vast majority of the population, but the truth is that with the constant changes to the state pension goalposts, we will all need to take more responsibility to provide for ourselves and start saving from as early an age as possible. Somebody leaving university at age 21 potentially has 34 working years ahead of them before reaching the age of 55. As it stands at the moment, when taking into account tax relief opportunities and investment growth, there is a real possibility that the lifetime allowance can be exceeded.

This maximum annual figure is well within the current annual allowance restriction of £40,000, which is the maximum amount that can be contributed to a pension in each year, unless the salary is lower, in which case this is limited to the income taxed earnings. It should be noted that once an income is drawn from a pension, the individual’s annual allowance instantly reduces to £10,000 a year. Therefore, for those still in employment and wishing to continue to contribute to a pension can do so, but to a much lesser degree.

Once the contribution levels have been set and an income agreed, there must be an adequate investment portfolio in place, which is aligned to the individuals attitude to risk and will help to grow the pension funds in the pre-retirement phase and maintain the income for as long as possible. As exposure to risk is necessary for growth, such an approach would typically be suited to a client who is adventurous in their younger years and is happy to maintain this as close to retirement as possible.

Anyone contemplating such a long-term retirement approach should strongly consider consulting with an independent financial adviser, or planner, before instructing their pension providers to release funds; taking such action without gathering all the facts could lead to irreversible problems in the future.

A good IFA will take the time to get to know the client to ensure that they truly understand their personal goals. Once this has been established they can carry out a cash flow modelling exercise and a complete review of the client’s circumstances, before presenting them with a bespoke retirement strategy, tailored to their personal financial position and objectives.

The expert was Sat Singh, the chief executive of IFAs ContractorMoney.

Thursday 10th Mar 2016