The Advantages of Pension Drawdowns for Contractors
Posted by John Yerou
on February 13th, 2012 15:31pm in
Last Updated on November 25th, 2019 18:05pm.
Freelancers and contractors aged 55 and above have the potential to use a pension drawdown. Great. What’s that when it’s at home?
Drawdowns provide a tax efficient mechanism for accessing your pension fund. If you have pension savings of £50,000 or more, this method may provide better returns than an annuity.
Before we proceed, we’d better get the FSA‘s legal bit out of the way.
Anyone entering a pension drawdown arrangement should seek professional advice beforehand.
There. Wasn’t too painful, was it?
On that note, we’ve teamed up with Wealth Matters to help advise you on retirement planning in the most tax efficient way.
A pension drawdown lets you take up to 25% of your total pension savings as a tax free lump sum. The balance will remain in your pension fund to grow and provide your annuity.
What’s an annuity, again?
When you reach retirement age, you’ll have a pension fund put by. At this point, most people buy an annuity, which is a way of managing that fund.
An annuity provider takes this fund off your hands and provides you with a fixed annual amount for the rest of your life. That’s irrespective of how long you live.
To make sure the fund lasts as long as you do, they’ll invest your pension fund on your behalf. The earlier you retire, the greater the importance of buying that annuity.
But again, seek professional advice. Once bought, you cannot amend the annuity.
There is an(other) obvious flaw in this plan. If you die not long after you retire, the annuity provider has a great chunk of your cash you’re never going to use. That, as they say, is the gamble.
But it does explain why drawdowns are so popular. If you take the maximum 25% tax-free permitted, you know it’s in your account, no one else’s.
Why should contractors consider drawdowns?
The flexibility drawdowns provide suits many contractors. It helps them unlock their tax free cash early and then use it in the most appropriate manner.
Depending upon your age or situation you may want to:
- clear debts, loans and/or credit card bills;
- pay off the mortgage early;
- help your children get a footing on the property ladder, themselves;
- no ulterior motive there, then? ?
But don’t think you have to stop contracting to take your benefits. You can use your drawdown as soon as you hit your specified retirement age.
But do keep in mind that if you take a drawdown, you are reducing the funds available for when you retire.
Advantages of a pension drawdown
A pension drawdown offers you a degree of flexibility in the way you work. When you reach 55, you can assume a staged retirement if you wish to do so.
You could draw down 25% of your pension fund as a tax-free lump sum to buy an annuity to provide a fixed income for life.
This enables you to carry on investing your Ltd Company profits into your pension pot, allowing it to continue to grow.
With you topping it up and an annuity provider managing it, you’re building a stronger retirement plan every day. And that’s the whole point of any pension.
There is one other major advantage of opting for a pension drawdown we’re yet to mention. If you die, your beneficiaries receive whatever’s left in the fund as a capital sum, unlike with annuities.
Advantages of pension investments for limited company contractors
Pensions are one of the most tax-efficient ways for contractors to transfer profits out of their company.
Rather than pay in person, you can make pension contributions direct from your limited company. The benefits to you are considerable savings on both corporation tax and personal tax.
You may think there are limitations on how much you can contribute this way if you pay yourself a token ‘wage’. Even if you draw low salary and dividend, you can potentially make tax free contributions from your Ltd Company of up to £50,000 a year.
Are you miffed that you’ve missed out on this ‘trade secret’? Well, don’t be. You can claim back up to three years if you’ve NOT utilised the preceding three years’ pension allowance.
If that’s the case, you have the potential to contribute up to a one-off £200K into your pension in any given year. That’s £50k for the current year and £50k for each of the three you’ve missed.
If you’ve recently started contracting, starting a pension can seem like a minefield. No matter how old (young) you are, you should understand all the options available to you.
True, you may think that retirement is years away. Especially if you fear for the state pension in years to come as we do.
But why worry what the state’s going to pay out when you reach whatever theoretical age it will be when you get there? A calculated ltd company contractor pension could see that first drawdown in your hands sooner than you think.
Author: John Yerou
John Yerou is a pioneer of contractor mortgages and owner and founder of Freelancer Financials, Contractor Mortgages®, C&F Mortgages and Self Employed Mortgages, trading styles and brands of the award-winning Mortgage Quest Ltd.