Contractor pensions advice: Pensions for contractors
What is a contractor pension?
A contractor pension is an investment that is designed to provide an income later in life so that you do not have to work forever. There are certain tax benefits that HMRC offer 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.
Obviously, the earlier you start to plan for this stage of your life the easier it’ll be, although it really is never too late to start. 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.
There are two main types of pension available, and if you have been permanently employed before the chances are you have a pension. Your previous employer will have set up your pension as either a defined benefit pension (final salary) or a defined contribution scheme (money purchase).
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.
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 3 years and if they don’t want to join will have to manually opt out every time they are re-enrolled.
As a contractor running your own LTD 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 most clients ask us ways of, legally and ethically, reducing the amount of money they are going to give to the taxman. Broadly speaking, there are 3 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 are 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 of our contractor clients make their contributions directly from their Limited Company as employer payments and this will significantly 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 in April 2018. With your tax-free allowance reducing from £5,000 to £2,000 per year, this means that you will pay more tax on your personal income from your Limited (LTD) Company and contributing into a pension is therefore an even more appealing way of reducing your liabilities.
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, 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 best position to meet your retirement objectives.
As an established advisory firm, our contractor pensions specialist partner 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 £40,000 per year, or up to 100% of your earned income, though it may be possible to carry this allowance forward for up to 3 years. An adviser will be able to make sure you are paying in the correct amount and not causing unnecessary tax charges, whilst maximising these allowances for you. There is also a maximum you can hold in pensions over your lifetime of £1,055,000 which is now going to rise with inflation every year.
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 regulator and authorities have learned from these mistakes and 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.
What happens at retirement?
In 2015, HMRC brought in the biggest change to pension income in a generation. They 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 2 or 3 days per 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 and a professional adviser will be able to steer you in the right direction with this.
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 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, you are investing into the most appropriate name 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 going to get you to where you want to be.
unbiased.co.uk have completed a study that shows that people who seek advice with their pensions on average receive an additional income of £3,654 for every year of their retirement (based on a pension pot size of £100,000). Our contractor pensions specialist partner will offer you an initial consultation at our own expense and specialise in the flexible lifestyle and finances that come hand in hand with contracting. Their friendly team of Financial Planners look forward to being able to help put you in the best position possible for your later life.
Find out more about our contractor pension partner Raindrop here.