Paying into a pension personally has huge tax advantages, providing tax relief on your contributions at your highest marginal rate. This means if you’re a basic rate taxpayer, you only need to contribute £80 to a pension to get a £100 contribution. Those in the higher and additional tax brackets receive further relief via their tax returns.
The tax advantages are increased if you’re a contractor who has set up as a limited company and are looking to make pension contributions through your business. This is because you can also claim corporation tax relief on pension contributions made by your limited company.
Contractors sometimes neglect pensions, often because they have previously been employed and have left one or more company schemes behind, and hope that these will provide them with a sufficient income in retirement.
However, given the size of a pension that’s necessary to provide you with a comfortable income when you stop work, it’s important to continue saving for retirement when you go it alone. It’s fairly simple to set up a new pension to pay in regular premiums (and lump sums if the business is doing well). You can also transfer old pensions into your new scheme, where appropriate.
Once in your pension, your money will be invested so it can potentially grow and be used provide you with an income when you stop work. When you reach retirement, you’ll be able to take 25% of your pension tax-free.
While you can make personal savings on pension contributions by receiving government tax relief, this is limited to £40,000 per year or 100% of your qualifying earnings, whichever is lower.
Many company directors pay themselves a small salary and top up their income with dividends. As dividends don’t count as qualifying earnings for the purposes of pension contributions, you could face a strict limit on how much you can personally pay into a pension each year if you’re in this boat equivalent to your minimal salary.
One way to get around this is to make pension contributions directly from your limited company, which doesn’t have a limit linked to your salary in terms of how much you can pay in (although the contributions must pass the ‘wholly and exclusively for the benefit of trade’ test from HMRC).
You can contribute pre-taxed income from your company to your pension, saving 19% corporation tax immediately on pension contributions. This means to receive a gross pension contribution of £100, you only need to make a net contribution of £81.
You’ll also save on National Insurance contributions, as companies don’t have to pay National Insurance contributions on payments made into authorised pension schemes. This saves a further 13.8%, bringing the total saving up to 32.8%. Depending on your tax position, this may be more beneficial than making pension contributions personally.
The above examples assume you are outside IR35. IR35 was introduced in April 2000 as a way of preventing contractors from financially benefiting from the tax advantages of being a contractor, when they are actually doing the same work they would if they were directly employed by the company they are working for.
If you are caught by IR35, then the tax benefits of contributing to a pension through your limited company are even greater, as you not only save income tax that you’d normally pay, but also employer and employee National Insurance Contributions.
Many contractors believe that individual savings accounts (ISAs) are the best way to save tax-efficiently. However, while you don’t have to pay income tax or capital gains tax on returns from ISAs, you don’t receive tax relief on the payments you make into these savings accounts.
This means you could lose out by just paying into an ISA because you aren’t getting that valuable top-up from the government in the form of tax relief.
Another reason to pay into a pension is that the sum invested remains free of inheritance tax all the while it’s in a pension wrapper. This is not true of ISAs, which are added to your estate on death and taxed alongside all of your other assets.
However, while pensions have their advantages, there are downsides also. Perhaps one of the biggest is that you can’t access these savings until you reach the age of 55, so you’re locking away savings for the long-term with a pension in a way that you’re not with an ISA.
It’s therefore usually a good idea to saving into both pensions and tax-free individual savings accounts. That way you can use your ISA savings in the run up to retirement, as well as for any emergencies that arise, followed by your pension when you eventually stop work.
Once you do reach the age of 55, changes to pension legislation in April 2015 mean that you’ll have much more flexibility over how you use your retirement savings.
Previously, the only option for most people was to buy an annuity, or income for life, from an insurance company. Annuity rates are currently low and, when you die, the income from them usually dies too.
Now there are other options available, namely ‘flexi-access drawdown’, where your money is invested throughout retirement and you then take a regular taxable income from these investments. Alternatively, you can simply take lump sums out of your pension as and when required.
Both methods of drawing down your pension are subject to tax in different ways, but the fact that you can dial up and down income from a drawdown fund may save you tax in the long-run over a regular annuity income you can’t alter, especially if you have other income streams funding retirement.
One of the biggest benefits of the pension reforms is that contractors can now pass their pension assets to beneficiaries without any tax charge if they die under the age of 75.
Prior to the changes, you would have had to pay a 55% death tax charge on a pension left to you by someone else if you’d already started taking an income from it, or had received any tax-free cash.
If you die after the age of 75, you can still pass your pension on to your loved ones, but they will have to pay tax at their marginal rate of tax on any income they receive from it.
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