Contractor pensions advice: Pensions for contractors

What is a contractor pension?

What is a contractor pension? A contractor pension is an investment that is designed to provide an income later in life. There have been many helpful reforms and changes in the last decade to pensions -- so we can now consider pensions as a significant, tax-free savings vehicle for a contractor’s retirement, providing a secure income or flexibility to take what you wish when you may need it.

There are certain tax benefits that HMRC offers to people who wish to save towards their retirement to encourage individuals to take more control over their retirement planning, rather than relying on state benefits.

In summary, as a contractor, you can make contributions to a pension in three ways:

  • 1. From your own personal money
  • 2. Directly from the income in your company bank account, or
  • 3. Via an umbrella company that you are working for.
  • Most limited company contractors will make their pension contributions through their company as this is more tax-efficient or, if you’re an umbrella contractor, via salary-sacrifice.

    Obviously, the earlier you start to plan for this later stage of your life the easier it’ll be, although it really is never too late to start. Delaying your pension savings can have a much larger impact that you may think, see here if you’re in any doubt!

    Discussing plans for when we stop working is an inherently personal thing, with each of us having different priorities and objectives. However, no matter what our plans are, pensions are the best option for retirement planning due to the various additional benefits offered with them. Our financial partners will provide rounded advice specific to your situation which will help you achieve your financial goals, whatever they may be.

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    There are two main types of pensions available, and if you have been permanently employed before, the chances are you have a pension or many pensions. Your previous employer will have set up your pension as either a defined benefit pension (‘final salary’) or a defined contribution scheme (‘money purchase’).

    Nowadays, final salary pensions are few and far between as they have become prohibitively expensive to maintain for employers and are now mainly only found within the public sector. The income you receive from a final salary scheme is based on the length of your service; how much you were paid when you left employment (hence ‘final salary’) and the accrual rate of the scheme. You, as an employee, will normally pay into the pension but the employer will make the largest contributions and they will guarantee the income level you will receive.

    Money purchase schemes are much more common in modern times. These are an investment that you, and your employer, will have contributed to. The income you receive when you stop working will be dependent on how much has been contributed, and the performance of the investments. Under the Pension Freedoms Act of 2015, there are a variety of options available to you once you stop working. Beyond making contributions on your behalf into your pension arrangement, your employer has no liabilities towards your savings, meaning that it is much more important for you to review your pension on a regular basis.

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    Employers Obligations for contractor pensions

    Since February 2018, all employers must ensure that there is a pension scheme in place for all their employees. This is a relatively new piece of legislation called Auto-Enrolment and has been phased in since October 2012, as a way of the government addressing the growing number of adults reaching retirement age with no provisions in place. Employees, as long as they meet certain criteria, will be automatically enrolled into the scheme every three years and if they don’t want to join, will have to manually opt-out every time they are re-enrolled. If you are an umbrella contractor, then your umbrella provider will provide an ‘AE’ pension for you, but in most cases, you will be unable to make salary-sacrifice contributions to this arrangement. However, that aside it will offer you a basic level of pension savings.

    As a contractor running your own limited company, you will not normally have to have an auto-enrolment pension unless you have employees within the business. Most contractors chose not to have an auto-enrolment pension as they tend to be basic and not very flexible, which is less than ideal when you have an irregular income.

    Tax on pensions for contractors

    When you start working on a short-term contract basis you are taking more risk and you must manage your affairs in more detail than when you were permanently employed.

    One huge consideration is tax and often contractors want to know ways of, legally and ethically, reducing the amount of money they are going to give to the taxman. Broadly speaking, there are three ways you can be remunerated; PAYE salary, dividends or contributions to your pension. Pensions are a great way of reducing your tax liability as HMRC is keen for people to build up their own wealth for retirement and not rely on state provisions. As such, there are a few different ways of obtaining tax relief on pension contributions and it’ll depend on where the money is coming from.

    Most contractor clients of our financial partner Yolo Wealth make their contributions directly from their limited company as this will reduce your liability to corporation tax. Personal contribution tax relief is calculated slightly differently, based on what income tax rate band you fall under, but generally employer payments are more efficient for contractors.

    Tax on dividends changed significantly back in April 2018. Since then the allowance for tax-free dividends has been reduced significantly, and as of the current tax year - 2024/2025 - this allowance is just £500.

    This means that you will pay more tax on your personal income from your limited company and contributing into a pension is therefore an even more appealing way of reducing your liabilities.

    If you are working through an umbrella, it may be possible for you to sacrifice some of your gross contract income towards your pension. This is a way for you to significantly reduce your liabilities. Salary sacrifice will reduce not only your income tax liability but your national insurance contributions too.

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    How much should I pay into my contractor pension to get a comfortable retirement?

    This is a question that we get asked a lot, and there is no prescribed answer. Every person has a different idea of what a comfortable retirement is, with varying ideas of when or how they want to retire, making it impossible to have a one-size-fits-all approach. Everyone has a different budget which will influence what level of contributions are affordable, and this needs to be assessed and professionally advised on to ensure that your day-to-day finances are not being overstretched, while putting you in the right position to meet your retirement objectives.

    As an established advisory firm, our contractor pensions specialist partner Yolo Wealth has years of combined experience advising clients on how to achieve their goals and they are experts at setting up and managing a range of investment solutions, specialising in the uncertain nature of contracting. They will analyse your current situation and affordability, while offering specific individual advice on how much you can contribute and make sure that the solution has flexible terms so that you can pause or change your payments in line with your contractor lifestyle.

    There are limits to how much you can pay into a pension per year. The maximum is £60,000 per year, or up to 100% of your earned income, though it may be possible to carry this allowance forward for up to three years. An adviser will be able to make sure you are paying in the correct amount and not causing unnecessary tax charges, while maximising these allowances for you.

    Pensions are risk-based investments and as such their values are going to fluctuate. If at the start you’ve been well advised, then this risk can be managed. It is important that you are investing in funds that are appropriate for your appetite, experience and capacity for risk and your affordability for investment is assessed by a professional.

    There have been some horror stories in the past of pension schemes collapsing such as Equitable Life. The pensions regulator and UK authorities have largely learned from these mistakes, so the institutional risk when investing in a money purchase pension is minimal. Even if the provider does collapse in the future, there are now compensations available via the Financial Services Compensation Scheme which will limit any losses realised by the individual investors. Some pension contracts are protected up to 100%.

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    What happens to my contractor pension at retirement?

    In 2015, the government introduced the biggest change to pension income in a generation. The government said that people should be able to choose how and when they receive their pension income. Prior to this change, retirees had to take their income as a structured annual income, which was set for the rest of their lives when the funds were initially accessed.

    Now, you have a choice of how you draw the income and you can, with the right advice, use the funds to provide a tax-efficient income which will suit your changing lifestyle. Many contractors will not get to a certain age and never work again, some will opt to carry on working in some form, be it two or three days a week, or move into a more consultancy-based role where they do not have to be in the office every day. Therefore, their income should be adaptable and flexible to fit in with their life. A professional adviser will be able to steer you in the right direction.

    What happens to my funds when I pass away?

    Never a popular conversation, but an important one nevertheless, is what will happen to your pension once you die. Under these new pension freedom rules, it is now possible for your beneficiaries to maintain your funds within a pension wrapper to maintain its tax-efficiency. There is also the choice to receive the funds as a tax-free lump sum if you were to die before the age of 75 and it is important to remember that pension funds do not form part of your estate for Inheritance Tax purposes, making them a very tax-efficient way of passing on wealth to the next generation.

    How do I go about setting up a suitable contractor pension?

    On the market today, there are a plethora of providers offering pensions with thousands of funds to choose from. If you are going it alone, you need to be confident that you are investing in the most appropriate scheme and getting the returns you deserve for the risk you can take, while not paying too high a price for this. You will also need to ensure that a pension is the correct vehicle for you; that you are investing into the most appropriate type of pension or investment for your situation and that the ownership of the investment is correct.

    If you use a professional financial adviser, they will take away a lot of the worry and headache in choosing where to invest and will be able to give you specific personal advice about how much you should be contributing. Advice is now a fee-based service but for that fee you will be given peace of mind and advice that is much more likely to get you to where you want to be. In fact, have completed a study that shows that people who seek advice with their pensions on average are nearly £48,000 better off in pensions and financial assets compared to those who don’t take advice.

    As a contractor pensions specialist partner, Yolo Wealth will offer you an initial consultation at their own expense and remember, they specialise in the flexible lifestyle and finances that go hand-in-hand with contracting. Yolo Wealth founder Angela James has over 10 years’ experience of advising contractors, and truly understands the complexities for contractors and how to consider this into your longer term financial planning.

    Approver: Quilter Wealth Limited & Quilter Mortgage Planning Limited. 24th June 2024

    Tax treatment varies according to individual circumstances and is subject to change.

    The value of pensions and investments and the income they produce can fall as well as rise. You may get back less than you invested.

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