Everything You Need to Know
Introduction to Contractor Pensions
One of the few downsides of contracting is that you have to take care of things like pensions yourself – they aren’t automatically handled by your employer. And make no mistake, a pension is just as important for you as it is everyone else. With a population that is continually ageing and an economy that seems to lurch from uncertainty to uncertainty it is more important than ever to have a good plan and pension in place for your golden years. Government pensions will be a bit of a joke in a few years time so it is up to you to make sure you build a decent nest egg. And the good news is that contractor pensions are one of the few excellent and reliable tax breaks that contractors are offered and which they should take full advantage of. Any contractor should ensure that they maximize the full potential of this particular tax break as soon as they start contracting – once they have a contractor pension up and running they can pay money directly into it and bypass both income tax as well as employee (and employer) national insurance contributions. That money is then going to sit there tax free in the pension fund and will grow and grow until it can be accessed from the age of 55 onwards.
How You Go About Investing in A Contractor Pension
There are two ways to go about investing – either through a limited company and via the employer contribution, or using a personally-funded pension plan. And if you pay in via a PAYE umbrella company you will also receive significant further tax advantages as part of the new rules on pensions – the so called liberalization of the pension regulations – that came in midway through 2006. As Tony Harris of Contractor Financials pointed out, from that point on there was now:
”For all but a few very high earners, in effect there is now virtually unlimited scope to contribute funds from your gross contract, into a pension fund. If Freelancers have the scope to cover bills etc by other means, they could avoid paying tax and NI on almost all of their contract income.”
How this works is that so long as your umbrella company has a decent pension scheme in place you will now be able to use something called ‘salary sacrifice’ in order to contribute your pre-taxed income to your pension. And therefore before your umbrella company takes the PAYE and the NIC’s they will put your pension contribution into your pension fund and then take the tax from your earnings. It is worth illustrating just how beneficial pensions v salary can be in terms of tax:
Suppose you have £200 of your income and you pay tax at the higher rate of 40%. You have the choice of either paying that £200 into your umbrella company pension fund or taking it as pure salary through the umbrella. If you decide to take it in the form of salary then you will pay £24 of employers and employees National insurance contributions that will leave you with £176. You will then have to take of another £72 of higher rate income tax. This will leave you with a total take home pay of £104.
For illustration’s sake if you were to take the whole amount then all £200 would go into your pension fund and be growing year on year in a tax-efficient account.
This Sounds Great – How Much Can I Invest Then?
This is why it is such a good tax break for contractors – HMRC has said that contractors are permitted to invest up to £50,000 (cut to £40,000 in 2014) per year into their pension fund without paying tax. Additionally, if they haven’t been able to take advantage of this tax break before then you are allowed to use the previous three years worth of allowance in the same year. This offers an incredible £150,000 (or £120,000) worth of pension fund in one year that will be completely tax-free. All of this is subject to a lifetime contribution limit of £1.5 million (£1.25 million from April 2014).
How Can I Choose A Decent Pension Provider?
If you are out on your own working through a limited company then you will need to do a lot of research to make sure you get the right sort of pension for you. If you work for a good umbrella company you will find that they have taken care of that for you and have deals in place with quality pension companies. Go through the contractor forums and sites and chat with other contractors to find out which umbrella companies and pensions they recommend.
What About Auto-Enrollment?
The government has become concerned recently that its’ citizens are living too long now and has therefore introduced rules to ensure everyone has a pension to look after them when they retire. Consequently they have introduced auto-enrollment for workers to make sure they contribute to a workplace pension and to ensure that companies do it for them. So, ever since last year employers have been required by law to enroll their workers into their pensions and this has had an effect on umbrella company contractors. Now, all employers, including umbrella companies will have to ensure the contribution of their members. And employers are now mandated to contribute a minimum of one percent of the qualifying earnings into the pension, which will rise to three percent in 2018. Similarly the employees (or contractors) will be required to contribute no less than one percent at the moment and a massive five percent by 2018.
Many umbrella companies have a bit of time yet before the auto-enrollment rules kick in so it is worth talking to your umbrella company to find out when they qualify.