Self-employment is growing in the UK, with 4.25 million workers self-employed in 2023, compared to 3.2 million in 2000. Working for yourself has many advantages, such as more freedom, the opportunity to work from any location you choose and it puts you in the driving seat, but one of the downsides is that along with an absence of holiday and sickness pay, you have to fund your pension.
Anybody employed by a company or organisation, has to pay into a pension under current legislation and their employers must also pay in. Employer contribution rates vary and some pension schemes, such as the one run by the NHS which makes a 20.6% contribution to pension pots in England and Wales, are very generous, which may take some of the pressure off the individual to make such large contributions
When should you start saving into a pension?
The earlier you start saving, the better, but your contributions will depend on individual circumstances. Anyone at the beginning of setting up their own business may not have the available funds for a pension..
How much you pay in and when you start, all comes down to affordability, lifestyle, and expenditure. It’s very tax-efficient to pay into a pension but you have to remember that the money is locked away for a long time and if you are in your 20s or 30s, you could be looking at a pot of money that is untouchable for 30 to 40 years. Legislation is continually changing which makes it even more difficult to plan ahead.
Self-employed and pension tax relief
When you work on an employed basis, the business will be required to pay directly into your pension, and that contribution is counted as a business expense and will be relievable to corporation tax. Under auto-enrolment rules, you as an employee will then have to pay a minimum of 5%, in most cases, of your monthly salary into a pension and your employer must pay at least 3%.
Everybody has an annual allowance, which is the maximum you can put into a pension each year. This was set at £40,000 a year for the last three tax years from 2020/21, but has recently been increased to £60,000, which is quite a sizable leap.
There is also scope to look back over the three previous tax years and use any unused contributions from those periods once the current year’s annual allowance has been maximised, known as your carry forward allowance. Net relevant earnings in the current tax year need to cover the contribution for an individual to be able to claim tax relief.
Historically there has also been a cap on the total value of pension benefits that could be built up over your lifetime without incurring a Lifetime Allowance tax charge. This value has fluctuated over the years, reaching a peak of £1.8 million in the 2011/12 tax year and falling to just £1 million in 2016/17. However, the Lifetime Allowance was recently removed in The Spring Budget 2023 although remains relevant due to the capping of tax-free cash at 25% of the most recent Lifetime Allowance figure (£1,073,100). Unfortunately, capping pension benefits had some unexpected consequences, mainly for those in Defined Benefit (DB) schemes, which resulted in almost unavoidable tax charges and effectively forcing some high earners, such as NHS surgeons and consultants, into early retirement.
Pensions for sole traders, partnerships, and freelancers
If you work as a sole trader, partnership (where two or more people share the profits and liabilities), or as a freelancer, you pay tax on any profits you make and are liable for any debts. You also pay class 2 and class 4 National Insurance. If you’re a sole trader, there’s only one way to pay into your pension. You make contributions from your net profit and most pension plans will automatically collect tax relief for you.
There are many types of personal pension plans available ranging from low-cost stakeholder pensions to self-invested personal pensions (SIPPs) which have wide-reaching investment options, including scope to hold commercial property. Discussing your needs with a financial adviser makes sense to settle on something suitable.
Pension payments if you own a limited company
If you own a limited company, profits are subject to corporation tax while the salary you take from the business is subject to income tax. You’ll also have to pay employee and employer National Insurance contributions.
You can fund a pension from your salary or from the business itself, and the most tax-efficient method will need to be decided. Pension contributions made from the business will be classed as a business expense, meaning that any money paid in, is exempt from corporation tax, which is currently charged at 25%. An additional benefit is that even if you draw a small salary with dividends on top, your pension payments won’t be affected by the 100% of net earnings rule – the business can pay up to £60,000 a year into your pension and it will be the business that benefits from tax relief on this amount.
How much can you pay into a pension each year?
You can only receive tax relief on up to 100% of relevant net earnings so for example, if you were earning £50,000 a year, you wouldn’t receive tax relief on the full annual allowance of £60,000 if you were to contribute this into your pension in a tax year, effectively negating the benefits of making pension contributions.
Rental income from residential properties doesn’t count as relevant earnings
If you earn extra income via rental properties, this will not count towards your net relevant earnings figure and you won’t receive tax relief if proceeds are paid into your pension, however, if the income is earned from furnished holiday lettings, you can.
Choosing a pension plan
Most employers will provide a pension to fulfill their auto-enrolment requirements. The majority of company pension schemes offer default multi-asset funds that blend riskier equities with potentially less risky investments such as bonds or alternative strategies. When you’re self-employed you have to make your own decisions and it can feel like a bit of a minefield. You’ll need to consider the provider’s charges, fund range, the level of risk, and the kind of operational functionality that you’re looking for. All pension providers will have their own operating systems and client interfaces that run in slightly different ways.
Choosing a pension plan will involve deciding on a number of factors all based on overall suitability, and devising an investment strategy will require further advice, focusing on your objectives i.e. how long do you expect to pay in, when do you intend to retire, how much money will you need to live in the style which you favour, what is your capacity for loss and what other income streams are you likely to have in retirement?
To obtain a very basic projection of how much your pension pot is likely to be worth when you retire, you can use a tool such as the Moneysupermarket pension calculator.
However, choosing a suitable pension can be a complicated business and it’s always best to seek advice from a financial adviser.
The state pension
If you have kept up with your National Insurance payments, then you will be eligible for a state pension from the age of 67. The current full state pension is £10,600 and will count as income for any income tax considerations. The state pension is normally paid gross using the first portion of your personal allowance, which is £12,570 for the 2023/24 tax year, frozen until April 2028.
Other ways to invest for retirement
Pensions are a tax-efficient way of saving for your retirement but they’re not the only way of investing your money for the long term in a tax-efficient manner. You could also save money using the following –
- Stocks and shares ISA – you can pay up to £20,000 each tax year in an ISA wrapper and gain access to investment markets. The beauty of this wrapper is that any capital gains you make are tax-free and any interest or dividends paid do not need to be considered for income tax purposes. Historically over the long term, investments have outperformed cash, and making use of an annual ISA allowance as part of a wider retirement planning strategy makes sense. Please note that past performance is no guide to future performance.
- Lifetime ISA – if you are aged between 18 and 39, you can open a Lifetime ISA, known as a LISA. You can invest up to £4,000 a year and the government will pay 25%. You won’t be able to access the funds until you reach the age of 60 or purchase an eligible property worth up to £450,000.
- Savings – when interest rates are high, savings accounts can deliver a good return, although historically, they have been outperformed by investments and are unlikely to outperform inflation, meaning a gradual reduction in overall purchasing power. You’re likely to get a higher return from a fixed-rate savings account, which will lock your money in for a period of time, but will not be able to access the funds, so you need to make sure this option is suitable. Your savings allowance means that you can earn up to £1,000 as a basic rate taxpayer from cash each year without having to pay any tax on the amount. This amount falls to £500 for higher-rate taxpayers.
In summary
It’s never too late to start saving for your retirement but the earlier you begin investing, the better. To ensure that you choose the right option for you and your circumstances, speak to a financial adviser.