Updated on: Jan 22, 2024
As a contractor, planning for your future and securing a comfortable retirement may seem like worlds away from the day-to-day blood, sweat and tears of working through your company for your end clients, but its worth some of your attention for a couple of reason. First, you are never too young think about retirement :), and secondly, pension contributions can be a very tax efficient way of getting money out of your business. This comprehensive “Guide to pension contributions for contractors” will provide you with all the essential information you need to make smart decisions about your pension contributions, maximize your hard-earned savings, and ensure you are taking advantage of the tax planning opportunities that you have.
Key Takeaways
- Understanding contractor pensions is an essential part of knowing all your tax saving options when working through your own limited company.
- Maximizing pension contributions can be achieved by understanding the £60,000 annual limit and utilizing unused allowances from previous tax years.
- It is important to understand the various pension withdrawal options available and their associated tax implications for when its time to hang up your boots and settle into your retirement lifestyle.
Understanding Contractor Pensions
Securing financial stability during retirement is key for contractors, therefore, pensions are an important part of the toolkit. Being aware of your options and setting up a personal pension will help you build a robust nest egg for your golden years. State Pension, although providing a basic retirement income, may not suffice, and guaranteeing sufficient qualifying National Insurance contributions is crucial.
The Role of Personal Pensions
A personal pension is a type of defined contribution scheme that provides flexibility and control, allowing you to manage contributions and withdrawals. With options like Self-Invested Personal Pensions (SIPPs), you can access a broader range of funds and investments compared to stakeholder pensions. However, keep in mind that SIPPs may have higher charges due to their increased complexity and the wider range of investments available.
Employing a financial adviser is often advisable when setting up a SIPP, as they can help you make informed decisions about your investments and navigate the complexities involved. We are big fans of keeping control of your finances and a SIPP puts you in charge of where and when your pension funds are invested.
State Pension for Contractors
While the State Pension provides a fundamental retirement income, contractors need to ensure they have enough qualifying National Insurance contributions to receive it. The full State Pension is currently £203.85 paid out weekly. This equates to £10,600 per annum. If your National Insurance record is irregular or you have years with low earnings, you can make voluntary contributions to fill the gaps.
A record of at least 35 years of National Insurance contributions is required to receive the full amount of New State Pension. This fulfilling of eligibility criteria is mandatory for claiming this pension. If you have less that 35 years of contributions your state pension is pro-rated down. You need a minimum of 10 years NIC contributions to qualify for the state pension.
We always recommend to our clients that they take a mixture of salary and dividends from their business. The benefits to taking a salary are (a) its tax deductible for the business (b) an annual salary of £9,096 (for the 2023/23 tax year) means the year counts as a qualifying year for state pension eligibility even though you pay no PAYE or NIC on the annual salary.
Tax Efficiency and Contractor Pension Contributions
Making pension contributions from your company is a tax effcient way of extracting funds from your business. As a contractor, you can consider limited company contributions, personal contributions with tax relief, and payroll contributions to maximize the tax advantages and grow your pension income. By doing so, you can also optimize your income tax obligations.
Our clients will nearly always take the first option (limited company contributions) but we wanted to cover off the other two options below just so you get an overall picture of how things work.
For contractors, the tax-deductibility of pension payments, which leads to a reduction in taxes and potential tax savings, makes it a tax efficient and attractive option.
Limited Company Contributions
Limited company contributions can reduce Corporation Tax and offer tax advantages for limited company contractors. By making contributions through your company bank account as an employer, you can leverage the tax efficiency provided by these contributions, which are considered an allowable expense. Keep in mind that HMRC will assess factors such as your total remuneration and the reasonableness of your work before permitting pension contributions via a limited company. This is the option that vast majority of our clients take. Its super easy to set-up, and administer.
Personal Contributions and Tax Relief
Typically when you make personal pension contributions into your pension fund, your fund provider will claim 20% in pension tax relief from the HMRC. This is commonly called tax relief at source, And makes the administration around getting the tax relief very simple to operate. You can contribute up to 100% of your salary (so for our limited company contractors who receive a salary of £9,096 per year, they can contribute a maximum of £9,096 in a year) or up to £60,000, whichever amount is less. For our limited company contractor clients to make personal pension contributions, they would need to be using their dividend income to contribute. Dividends do not get any corporation tax relief, and are also taxed through the personal tax return system. If the contractor were to contribute directly from their limited company, they do get the corporation tax relief, and the dividend tax would no longer apply. Taking both of these factors into account, a contractor is significantly making company pension contributions, which is why none of our clients use this method either.
Contributions through Payroll
Making pension contributions through payroll involves automatic enrollment, contributions from both the employer and the employee, payroll deductions, and compliance with regulatory requirements. It’s a structured system designed to encourage retirement savings for employees, and a workplace pension scheme like this is most commonly used where you are working full time for an employer. As a limited company contractor this method would rate as the most complicated and burdensome way of contributing to your pension, which is why none of our clients use it.
Choosing the Right Pension Provider and Plan
Selecting the right pension provider and plan involves considering factors such as:
- Flexibility
- Reputation
- Fees
- The differences between SIPPs and stakeholder pensions
Ensure your pension plan is adaptable to changes in your working arrangements and legal structures, thus providing the necessary career-long flexibility.
Flexibility and Adaptability
Contractors need flexible pension plans that can adapt to changes in their working arrangements and income fluctuations. A flexible pension plan should offer options to:
- Adjust contribution amounts in accordance with changing income
- Allow for catch-up contributions during times of higher income
- Allow for additional contributions when possible
This flexibility ensures that contractors can effectively manage their pension funds and savings based on their unique circumstances.
By offering these flexible options, pension plans can effectively manage the changing financial circumstances of contractors.
Reputable Institutions and Fee Structures
For the long-term growth and stability of your pension fund, it’s important to invest in a reputable and reliable institution. Some of the most highly rated pension providers for contractors in the UK include Pensionbee, AJ Bell, Interactive Investor, iSIPP, Penfold Pensions, Bestinvest, Hargreaves Lansdown, and Scottish Widows.
Providing pension advice is a regulated activity and we are by no means recommending these firms to you. We’re just giving you some ideas 🙂 Having a transparent fee structure in place helps you understand the costs associated with your pension plan, enabling you to make wise investment decisions.
SIPP vs Stakeholder Pension
SIPPs offer more investment options than stakeholder pensions but may have higher fees and require professional advice to set up. Stakeholder pensions are a straightforward form of personal pension that provides convenient and cost-effective access to pension savings, while SIPPs provide a more extensive selection of investment options and greater authority over investments.
Before selecting the option that best suits your needs, consider the benefits and drawbacks of each, but as mentioned above we’re a big fan of the SIPP pension because it puts you in more control.
Maximizing Pension Contributions
Understanding the £60,000 annual limit, making use of unused allowances, and passing the ‘wholly and exclusively’ test for employer contributions are key to maximizing your pension contributions. By maximizing your pension contributions, you can enjoy the full benefits of tax relief and watch your retirement savings flourish.
£60,000 Annual Limit
The annual pension contribution limit is £60,000 for the 2023/23 tax year (it was previously £40,000 per year), and contractors should be aware of potential tax charges for exceeding this limit. To effectively manage your pension contributions and avoid exceeding the annual limit, consider the following:
- Monitor your pension contributions from all sources.
- Consider carrying forward unused contributions from previous years (if any).
By following these steps, you can ensure that you stay within the annual pension contribution limit and avoid any unnecessary tax charges. If you do exceed the annual pension contribution limit then any amount contributed over the threshold not only doesn’t get receive tax relief, but it also gets taxed at your marginal tax rate.
Utilising Un-used Allowance
Unused allowances from the past three tax years can be carried forward, allowing contractors to maximize their tax relief on pension contributions. To utilize this carry forward rule, you must have been a member of a UK-based pension scheme during those three years and generated a minimum amount of profit equivalent to the desired contribution in the current tax year.
The ‘wholly and exclusively’ Test
The ‘wholly and exclusively’ test ensures that employer pension contributions are made solely for business purposes to qualify for tax relief. To be eligible, the contribution must be funded through a legitimate remuneration agreement.
The main issue that can occur here is where it may be perceived that the director is stripping cash from their company purely for tax minimization, and that the pension contributions are largely artificial. To help protect against this regular and consistent pension contributions are ideal.
Consolidating Pensions and Managing Multiple Plans
Combining pension pots can simplify management, reduce fees, and accelerate pension growth for contractors with multiple pension plans. By consolidating your pensions into a single pension pot, you can enjoy a more streamlined approach to managing your retirement savings and ensure you’re making the most of your investments.
Preparing for Retirement and Pension Withdrawals
Understanding your pension withdrawal options is a critical part of preparing for retirement, such as pension drawdown or purchasing an annuity, as well as the tax implications of these options. The legal age to access a defined contribution pension is 55.
When its time to retire your options for drawing down on your pension pot include;
(a) Tax-Free Lump Sum (25%): A lump sum can be taken tax-free, providing flexibility for early retirement expenses like travel.
(b) Annuity: An annuity offers a guaranteed income for life, but lacks flexibility and may take years to recoup the initial investment.
(c) Drawdown Scheme: Provides flexible access to the pension pot, but the fund may deplete over time and is exposed to market fluctuations.
(d) Taxable Lump Sums: After the tax-free lump sum, the remaining 75% is taxable as ordinary income. Taking the entire remaining pot as a lump sum may result in significant tax.
(e) Combining Methods: Individuals can use a combination of strategies for income, such as starting with drawdown and later purchasing an annuity. This allows for a balance of flexibility and security.
Once you get to this stage, some careful consideration and planning based on individual circumstances is called for. Get in touch with your pension provider and a financial advisor and start mapping out your route to a nice comfortable, tax minimised, retirement.