When you make the decision to become a contractor, you are foregoing many of the benefits associated with a full-time job. One of these is a company pension, and it’s becoming an increasingly important feature of modern life to help provide for retirement.
With an aging population, setting aside money as a pension pot is crucial for you to live comfortably in your senior years. While it might seem like a long way off, the last thing you want is to be struggling to afford a roof above your head when you are elderly, all because you didn’t plan ahead.
You Need Pension Provision
Anyone who works a full-time job will more than likely be enrolled in a pension plan, often organised and provided by their employer. These plans take payments over a working lifetime, invest the capital, and return the applicable amount in chunks once the qualifying terms have been met.
As a contractor, you can’t rely on working to put food on the table until the day you die. That means you need to set money aside as quickly and as diligently as possible for your future, so you have as much money as possible to live on when your income streams finally stop.
Everyone needs to think about their pension provision, but it’s even more important for those under their own employment, like contractors, and taking the right steps now can set you up with a more comfortable pension for later life, with the added benefit of saving tax in the process.
Save tax whilst providing for your future
Paying into a pension fund is tax deductible, so contractors who choose to do so now can save money today on their income for tomorrow.
The government wants people to provide for their own pensions, and encourages this through deferring applicable taxes. This means that there is a financial incentive for contractors and freelancers to save money for their pensions as soon as possible, to reduce their tax liability, whilst feathering their nest for the future
State pension for contractors
Contractors are in a tricky position when it comes to the state pension, with many unable to claim the full amount due to them as a result of interrupted National Insurance payments.
Contractors often choose to pay themselves a smaller salary so they can avoid National Insurance payments. This is good in the sense of saving on your tax bill in the short term, but means that the state pension entitlement you receive will be proportionately less. As a result, many contractors choose to pay into a private plan, as the main source of their income beyond retirement.
Choosing your pension plan – personal/stakeholder or executive
Since changes to tax law (IR35 in particular), pensions remain one of the major tax breaks still available to those working as contractors, and you’ll want to make sure you take advantage of them.
There are two main types of pension plans you will likely choose from:
This is the most common type of pension plan you will encounter, and one that pretty much anyone can take out. Provider charges and fees are capped at 1%, and payments of up to £300 per month can be made before there are any further tax complications.
A major advantage for contractors choosing stakeholder pensions is that they can nominate a base year of earnings from any of the past 5 years. You can then nominate your highest grossing year as your base year, and pay more into your pension than would otherwise be the case.
The other major type of pension you are likely to encounter is the executive pension plan, which is offered to those running businesses who have previously neglected pension planning and instead focused on building their business. The calculations used for working out how much you can pay in to an executive pension plan are different from those used in personal plans, so you may be able to pay in more each month than would otherwise be permitted.
Other Issues To Consider When Thinking About Your Pension– How many years stand between now and when you wish to retire? The longer there is between when you start building up resources for retirement and when you need to start drawing an income, the more time the investment will have to grow.
– Which investment vehicle will you use? Examples include stocks, bonds, ISAs, property and cash and each has its advantages and disadvantages, including; accessibility, risk, tax treatment and cost, so it’s worth doing your homework.
– How much of your income is available to invest towards retirement planning? In most cases, in order to build up sufficient capital, a significant percentage of income has to be set aside to meet this objective. However, there is little point in concentrating on retirement planning at the expense of other priorities. As with most things in life, it is a matter of balance and compromise.
– What income do you require in retirement? This is one of the most important aspects of retirement planning, and also one of the hardest to establish. It is usually a considerable number of years away, and involves a lifestyle that it is difficult to envision at a younger age. There are also a number of variables outside your control that can impact the situation, such as inflation, levels of state support, investment returns, and so on.
– Nevertheless, it is vital to set an income objective at the outset, and revise this as time passes. A useful starting point may be to look at your current outgoings and decide which will continue into retirement, which will cease (e.g. mortgage repayments) and which ones you may need to add in as you get older, e.g. higher health care expenditure.
The State Pension
Alongside occupational pensions, contractors can expect to benefit from state support, in the form of the Basic State Pension and the State Second Pension (S2P). The amount payable varies depending on contributions to National Insurance.
The majority of contractors will be entitled to the maximum Basic State Pension, which is maxed at £119.30 per week for tax year 2016/2017.
The S2P was scrapped in 2012/13, apart from for Final Salary Schemes, where S2P remains for the time being. This was based on the individual’s record of NI contributions, and their income level. S2P benefits accrued up until 6 April 2012 are still protected, and will still be paid on retirement.
Paying into a pension scheme can be hugely tax efficient for contractors. Contributions of up to £40,000 per annum can be made without further taxation, with any amounts over and above this subject to measures to recoup marginal tax relief.
In some circumstances, it is possible to ‘carry forward’ unused Annual Allowance amounts from previous years. This means in better years, you can set aside a greater proportion of your income up to the maximum of £160,000 over 4 years, in order to maximise relief and the overall savings to tax.
The Lifetime Allowance is £1 million from the 2016/17 tax year, and tax relief is available on contributions at the marginal rate of tax applicable for the individual.
Pensions can quickly become a challenging subject, especially for contractors with no formal legal or financial background. As a result, many contractors choose to seek professional advice on these issues. iContract makes this possible by putting you in touch with the experts in just a few clicks.
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