With auto enrollment looming, many contractors, and small business owners are thinking again about how to better prepare for their financial future.
As a specialist contractor accountant with clients based throughout the UK, there are a number of questions that we are asked regarding contractor pensions.
We have put together some overall guidelines to help you understand the options available when it comes to planning for your retirement.
As a limited company contractor there are two ways that you can contribute to a pension, either from your individual funds or via your business.
Personal Pension Contributions
These are contributions made to a pension scheme from personal funds and as such attract personal tax relief. The pension provider will top up the contribution by 20% to give you basic tax relief, for example if you contribute £80 you will receive an additional £20, so a total of £100 is added to your pension pot.
Tax relief on personal pension contributions is capped at 100% of earned income and it is the topped up contribution that is taken into account, thus pension contributions in excess of salary are not normally efficient.
Company Pension Contributions
These are contributions made to a pension scheme from company funds and as such gain relief from corporation tax. Make sure that your pension provider is aware that the contributions are to be made from the company and they should be paid directly from the company account.
In 2006 HMRC changed the way that it allowed corporation tax relief on company pension contributions and as such they are no longer automatically eligible for tax relief. Contributions are only eligible if they are wholly and exclusively for the purpose of trade rather than the benefit of the employee/director.
HMRC accept that pension contributions are for the purpose of trade if the overall remuneration package of the employee/director is reasonable. This means that the salary and pension package as a whole should be considered and provided this does not cause the company to make a tax loss in any given year, the contributions will qualify for tax relief; this also assumes that the contributions are not excessive.
There are both annual and lifetime limits on the amount that can be contributed to a pension. The annual limit for 2014/15 is £40,000 and the lifetime limit is £1,250,000. If these limits are breached there will be additional tax charges.
Choosing a pension provider
When deciding on which pension provider to use you should avoid firms that ask for costs and fees upfront, to ensure that your contributions actually go towards your pension, this will be especially beneficial if you are only planning on contracting for a short period of time.
As a contractor you will ideally want to choose a provider that is familiar with how contractors work. These schemes need to offer flexibility around how much you put into your pension so you can increase or decrease your monthly contributions depending on your contract at any given time.
Your provider should also be a firm with a good track record in the field, one that is financially secure giving you confidence in their ability to look after your investment. Companies come and go in the pensions market and so it is important that you choose a stable provider who can provide a long-term commitment to you.
Who is affected by the 2015-16 changes
The big change affects 4.5 million people with Defined Contribution (DC) schemes.
Under these schemes your monthly pension savings go into a pot, which will eventually be used to buy an income for your retirement. You can now access that pot freely from the age of 55, with no cap on what you can take out – subject to tax.
Some people with Defined Benefit (DB) pensions, i.e. those which promise a particular annual income, will be able to swap them for DC schemes.
How much tax will I pay?
You can take 25% of your pension pot as a tax-free lump sum, or you can take out smaller amounts, of which the first 25% will be tax free on each occasion.
However you will have to pay income tax on the amount you withdraw over and above the 25% tax-free allowance.
If that amount, added to the rest of your income, exceeds £42,386 (2015-16), for example, you will pay tax at 40% or more.
If the amount exceeds £100,000, you will begin to lose your personal allowance, resulting in an even higher tax charge.
So careful tax planning is essential in this case.
Can I pass a pension to my dependents?
The new rules make it easier to pass pensions to dependents; If you die before the age of 75, the pension pot can be passed on tax free.
If you die after 75, and your descendants want the whole pot as a lump sum, they will have to pay 45% tax, instead of 55% previously.
It should be said however that the government is considering whether to reduce this to an individual’s income tax rate – known as the marginal rate – from April 2016.
Those who draw down income from an inherited pot will, in any case, pay tax at their marginal rate.
If I buy pension income, what tax will I have to pay?
Regardless of whether you buy an annuity (or income for life), or you opt to leave your pension pot invested and take income drawdown instead, you will only pay tax on the income received.
Anyone with total income below £10,600 in 2015-16 will not pay anything.
Are annuities still worth considering?
The pension changes mean that many people who would have bought an annuity, will not now do so.
Income drawdown is a more flexible option for many. and in fact it has not been compulsory to buy an annuity since April 2011.
At present, annuity rates are low meaning that your mention pot buys less of an annual income that it did previously, however for many people, annuities will still be the best option – or a mixture of an annuity and drawdown.
If I have already bought an annuity, can I see it?
In the March 2015 budget, the chancellor said he would make this possible, and the government will now carry out a consultation. This could allow you to swap your annuity for cash, from April 2016.
There is a question mark over the liquidity of second-hand annuities, and many suspect that those selling their annuities will find it hard to get a good price.
How much can I save into a pension?
From 6 April 2016, the maximum you can have in a pension pot will be £1m (reduced from £1.25m). This figure will rise with inflation from April 2018. The government says the change will only affect wealthy people.
But a 60 year-old spending all their £1m pension pot on an inflation-linked annuity could – according to current annuity rates – expect a maximum annual income of around £27,000. You can have a larger pension pot if you wish, but you will pay 55% tax on any withdrawals.
However, anyone in a DB scheme will be treated more generously.
Such schemes have a notional capital value, calculated by multiplying the annual income by 20. So if the scheme pays an income of £10,000 a year, the notional value of the pension pot is £200,000.
Given that the maximum pot will now be £1m, members of DB schemes can therefore expect annual incomes of up to £50,000.
The annual allowance for pensions savings remains at £40,000.