If you’re working as a contractor, there’s no one else to set up a pension for you and make pension contributions in your name. That means it’s essential to look into the pensions available for contractors as soon as possible to start building your own retirement savings.
With no employer contributions into your pension pot, contractors need to ensure they’re making the most of the pension payments they’re making during their working life.
Don’t miss out — make sure you’re not penalised with a reduced retirement income compared to someone who’s getting employer pension contributions just because you work for yourself.
The golden rule for all pension savers is that you should start as soon as possible, but this is even more important if you’re contracting. Employees get their pension topped up by their employer, but when you’re a contractor you are solely responsible for securing your retirement future.
The sooner you start saving for retirement, the less you’ll have to chip in each month to build a decent pension pot.
Some contractors find their income is erratic, so committing to larger monthly pension contributions if they start a pension later in life could be a struggle. That’s why it’s best for contractors to start pensions as soon as possible so monthly contributions can be more affordable.
Not only will your pension pot have more time to grow through contributions the earlier you start saving, but there’s also a longer period for investment growth.
Also, pension pots tend to be invested in higher-yielding — but perhaps riskier — assets when you’re younger. That’s because if there are any losses, your fund has more time to gain them back when you’re younger than if you’re retiring soon.
The closer you get to retirement, your investments tend to shift to safer options to try and ensure there are no sudden upsets that could adversely impact your retirement.
With many contractors being exempt from auto-enrolment if they’re a sole worker, there’s little pressure from the government for contractors to start pensions. However, the later you leave starting a pension, the more you’ll have to put into your pot each month if you want to achieve a comfortable retirement. You’re also throwing away valuable pension tax relief from HMRC each year.
One of the key decisions in setting up a pension is finding the best pension provider for your circumstances. When searching for a pension as a contractor, this can be especially difficult as you need to find a plan that will be flexible enough to accommodate the fact that your employment status and income is changeable.
For instance, you might have gaps in your future employment income and have to increase or decrease your monthly pension contributions depending on your finances at the time. That means that a pension with a minimum monthly payment is unlikely to be suitable for you.
When picking your contractor pension, you should shop around. Some of the things you should look at include:
The only pensions available to people currently contracting are private pensions, a type of defined contribution pension scheme. They’re essentially a pot of money that you pay into during your working life, which you then use to provide yourself with a retirement income.
While a contractor might have a defined benefit pension from a previous employer, they aren’t open to those currently working for themselves.
This leaves two main pension options open to contractors: stakeholder pensions and, for the more experienced investor, self-invested personal pensions (SIPPs).
Given that they’re more flexible when it comes to the size and regularity of contributions and also tend to have capped charges, stakeholder pensions might be better for contractors than SIPPs. However, this will of course depend on your circumstances.
Stakeholder pensions may also better if you’re new to investing and / or are unsure about the investments you’d like to make, as they offer a ‘default’ fund that’s designed to suit as many people as possible.
A SIPP, on the other hand, offers much more freedom and flexibility when it comes to managing your investments. With a SIPP, you or your investment manager is free to manage the funds as you see fit.
A self-invested personal pension requires far more involvement in terms of investment management than a stakeholder pension. That means it’s likely to be beneficial to speak to a pensions adviser to get financial advice if you’re considering using a SIPP for your retirement savings.
An adviser is well-placed to advise you on the best way to open a SIPP and the best investments to make given your circumstances and retirement goals.
If you work through your limited company you have a number of different ways to contribute to your pension. One is to pay in yourself, out of post-tax income, and reclaim the tax relief via your tax return if you’re a higher or additional rate taxpayer. Another way to contribute to a pension as a contractor is to do so via your limited company.
Of these two ways contractors can pay into a pension, doing so through your limited company is usually much more tax efficient as it offers the opportunity for both personal and corporation tax savings.
With corporation tax in 2019/20 at 19%, for each £100 of gross company profit the company pays £19 in tax.
From the 2019/20 tax year, there’s a new dividend allowance of £2,000. Above this limit, you have to pay dividend tax.
So if you choose to pay the remaining £81 out as a dividend in 2016/17 and you already have dividend income of £2,000, you’ll pay dividend tax on the £81.
How much dividend tax you’ll pay will depend on which tax bracket you’re in. A higher-rate taxpayer will pay 32.5% tax on this £81 figure, or £26.33.
This leaves you with a take-home dividend of £54.67 and a total payment to HMRC (corporation tax + dividend tax) of £45.33 out of the initial £100, or an effective tax rate of over 45%.
If your limited company instead contributes the £100 to a pension rather than paying it out as a dividend, it all goes into the pension fund with no tax payable.
This equates to tax relief of over 45%. If you were to make the same contributions out of post-tax income as a higher-rate taxpayer, you’d only receive 40% tax relief.
Head of Financial Planning at Drewberry
Contractors can save up to £40,000 each year into a pension as long as their adjusted income (taxable income from all sources + pension contributions) is less than £150,000. This is known as the pension annual allowance.
Contractors who work through an umbrella company may be able to use salary sacrifice to contribute to a pension scheme.
This means the umbrella company will contribute to a pension scheme on your behalf out of your gross income. Essentially, they take a chunk of your salary and pay it into a pension pot for you instead.
As a result, you not only receive tax relief but also relief from employees’ National Insurance contributions.
Meanwhile, the umbrella company gets relief on employers’ NI contributions and also gets to claim the contribution as a business expense, offsetting it against their corporation tax bill.
If a contractor who’s a higher-rate taxpayer takes £100 as a salary, they will pay £2 in employee’s National Insurance contributions, leaving them with £98. Higher rate income tax is levied at 40%, which takes off a further £40 and leaves the employee with a take-home (net) pay of £58.
However, if the umbrella company pays the £100 into a pension, the entire £100 goes into the pot without being taxed (up to the annual allowance).
Assuming a contractor is earning enough, they could contribute the maximum of £40,000 into a pension each year this way.
If haven’t made any pension contributions in the last three years, then providing you have sufficient earnings you may be able to make use of salary sacrifice alongside pension carry forward to further increase your permitted pension contributions in any given tax year.
Many people start contracting later in life, which means they’ve already set up and paid into various workplace pensions over the years. They may have accumulated several pensions from previous jobs.
This can be costly for a number of reasons, not least because you’re probably paying management fees and charges on each individual pot.
Moreover, it’s hard to keep track of how multiple pots are performing, and you may even have some lost pensions you’d totally forgotten about.
If this applies to you, it may well be worth asking a financial adviser to review your pensions. They can take a look at any arrangements you have an advise whether it would be advantageous to consolidate your existing pensions into one fewer plans.
Using a pension consolidation service can make keeping track of your savings easier and reduce the fees you’re paying. It will also be a much simpler process when you come to retire and want to start drawing on your pension savings.
It’s important that you get financial advice before considering consolidating your pensions, as it won’t always be in your interests to consolidate every pension you have.
This is especially the case if you have a final salary pension, or other types of pension with guarantees attached.
Senior Parpalanner at Drewberry
As well as a pension, contractors should also save some cash which is easily accessible to cover any short-term dips in income or gaps between contracts.
A cash ISA or instant access savings account is a good option for this. However, for longer-term investments, there are other options available, especially if you’ve already exceeded your annual allowance.
A good financial plan can help you make the right decisions when it comes to your finances. Make the right decisions today to build a more prosperous future.
Good financial planning with clear goals can increase your retirement income by as much as 53%. Old Mutual Redefining Retirement Survey
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