Why contractors need a pension more than ever
Trying to write a dynamic pension guide is like trying to get emotive over watching grass grow. But the truth is, pensions should keep us in the manner we’re (at least) accustomed after we retire. To make sure that happens, the seeds need planting early and watering on a regular basis.
Granted, lawns aren't the most spectacular feature in your garden. But they are the foundation around which every bloom thereafter adds life and depth.
In the same way, pensions aren't the most exciting thing we can do with our income. But essential to making life a bed of roses after we've submitted our last invoice? Oh, yes!
Pensions will save you substantial amounts of unnecessary tax
Most contractors fall into one of two categories; they've either:
- not yet committed to a pension, or
- don’t maximise the allowances that paying into a pension fund through their limited company avails.
Now’s the time to change all of that.
Post-IR35 regulation, pensions remain one of the few tax breaks afforded to all contractors. How? The trick is not to deduct pension contributions from your salary. It’s far more beneficial to contribute straight from your company bank account.
I say 'trick' but it's NOT. This method of saving for your retirement remains 100% legitimate and will see you save tax in any number of ways.
Because you transfer the contribution from your company bank account, it's not subject to income tax. Nor is it liable for employer’s or employee’s National Insurance.
Your pension will then also grow tax-free until you draw on it after retirement. Contributing thus is a lot more tax-friendly than investments you fund from your net income.
Once you draw your salary, it’s subject to all the usual deductions. In the case of your pension, these costs are completely unnecessary if you operate through a limited company.
What about my state pension? Can’t I claim that?
As a contractor, you’re presumably paying yourself a nominal salary. By paying yourself so little, you’re avoiding the double-edged sword of National Insurance.
On paper, this is a great plan. You’re paying for no-one else’s upkeep but your own. Those outgoings you’re saving are destined for your pocket, not the taxman’s. But here’s the catch.
The state pension is set up to pay out a full pension based on the NI you contribute through your earnings over a defined period. For the majority, that period is 30 years. The counter-effect of your 'nominal' saving is that you’re not accruing those “qualifying years”.
Your state pension will be severely reduced if you stop paying into the system over prolonged periods.
And it’s no use thinking that you can opt in and out. Declaring so much one month and nothing the next over a regular period will raise inquisitive eyebrows. The last thing any contractor needs is a visit from a representative of HMRC.
As a rule, contractors earn enough not to have to worry about a reduced state pension. However, that guaranteed future surety won’t happen unless you do something about it.
Careful planning at the outset is the only way to assure a comfortable post-retirement lifestyle. Start today and your future post-contracting self will thank you when the two of you meet.
Pension contributions can and should promote tax efficiency for limited company contractors. The government has manufactured it thus in alignment with its own philosophy.
The government believes it’s in every individual’s interest to save for their own retirement.
By offering us a tax-free way to build our pension fund, they're encouraging us to maximise our contributions. The taxman will take a cut upon our retirement; but even then, there's a completely free tax element.
Contractors can use employer contributions to turn company cash into personal income. As this method bypasses the taxman, it represents an attractive and savvy way to plan for their future. And it comes with HMRC’s blessing, to boot.
How do pensions save on my tax bill?
The best way to demonstrate how contractor pensions work is to offer you an example.
Let’s imagine you have £6,000 you wanted to save. If you withdrew that as salary or dividends you’d either pay income tax or corporation tax.
If you instead paid that sum from your company account to your pension fund, you’d pay no tax at all.
Your accountant will deduct the £6,000 from your gross salary or gross company profits. As such, it isn't considered in any tax calculations.
Furthermore, that money now belongs to you, not your company. It’s in your pension, ready to pay out during your retirement.
The affordability factor
There's something that you must consider before committing any funds to a pension plan. That is that once the contribution goes in, it’s locked away until you retire.
The temptation may be to stash as much cash away as possible to achieve the upper threshold. This will optimise your tax breaks, but that should never be the reason you save.
Cash flow is more important to a contractor business than saving extra, here and there.
If you have imminent major expenses or foresee lean times ahead, money in a pension pot is out of bounds until you’re at least 55. Even then, you won't receive the lump sum in one hit. 25% is usually the most you can withdraw in one hit upon reaching retirement.
Those newer to contracting should hedge their bets. If you find yourself with a little extra, build up an ISA as a safety net before locking your profits in a pension. ISAs give you instant access and may be a more appropriate savings vehicle in the early days of your business.
The intricate details of pensions can seem like trying to navigate a minefield blindfold. What’s not complicated is that they’re designed for retirement, not before.
That all sounds great. How do I pay in?
The first step is to contact an Independent Financial Adviser (IFA) who specialises in your niche. That's critical. Your IFA must be familiar with the tax saving availed of limited company contractors.
There are many different ways to save for your future. Your IFA will confirm which product(s) best fits your circumstances.
You could just move a little money from your company into your pension pot to get the ball rolling. That would mean paying a one-off annual contribution into a personal pension fund.
It's a common enough practise. Many limited company owners wait until their end-of-year figures before deciding how much to pay in.
Or are you looking for a more managed investment with a bit more financial clout?
This is where your attitude to risk will come into play. It’s critical to gauge your risk factor accurately. Contractors at different milestones in their career can choose to either be frugal or flamboyant.
How do I work out my attitude to risk?
Pensions have changed. The stability of a set percentage of your salary returning an assured amount is no longer failsafe. Far from it.
You choose the funds into which your contributions go; they in turn are subject to the whims of the stock market.
Over a long period, pensions do usually mature, and handsomely. But we must point out that investments reliant on global markets can shrink as well as grow. And this is what’s critical to remember: pensions are a long-term investment.
If you’re in your twenties or thirties, daily fluctuations in the markets mean little. Your fund has 25-35 years to correct itself, should the initial trend be downwards. So you can assume a greater attitude toward risk.
For those closer to retirement, the opposite is true. Any stock exchange setbacks won't have time to recover, so a more cautious approach may be advisable.
Don’t panic too much if you think choosing a set of investments is overwhelming. Many pension providers have a range of “off-the-shelf” portfolios. You can take them 'as is' or tailor them for whatever you determine level of risk is.
How do I manage my pension?
Your pension provider will manage your funds in the manner that befits your investor profile. Your profile is a result of your attitude to risk, circumstances and the goals you've set for retirement.
To determine the best fit based on your profile, we again encourage you to speak to an IFA. They'll get to grips with your current situation, first. Then, they'll help determine your pension's goals based on your aspirations and affordability.
This is another reason why choosing a pension advisor who understands contracting is key. They'll be aware that you may want to make one-off payments. Or that your contributions will be coming via your limited company.
They'll also manage your stocks and shares portfolio in line with market standards and best practises. It is, after all, in their interest that your pension performs.
The more your fund gains, the greater the value of their management percentage cut. And talking of charges…
…initial discussions will always be free of charge. Do be wary of advisors who ask for payment for a preliminary consultation.
Only when you have agreed the details and signed up should you have to pay any fees. Once set, you can focus on today, knowing that your contractor pension is looking after tomorrow.
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.