Self-employed people often find it harder than their employed peers to have the prospect of a comfortable retirement.
This is not surprising as the self-employed don’t benefit from an employer payment into a pension automatically set up for them. Employers must make a pension plan available and pay into it 3% of eligible employees qualifying earnings. The self-employed must find and fund their own pension arrangements.
State Pension Boost
Historically the self-employed have also missed out on the additional component of the State pension scheme which existed until 2016 and was paid on top of the basic state pension. Self-employed workers may only expect the basic State pension for credits earned up to April 2016, leaving another gap in their retirement funding.
From 2016 the State pension changed. For the first time, the self- employed can access the same state pension as the employed. From April 2016 those who pay Class 2 national insurance will get a full state pension once 35 years contributions have been paid to the new State pension scheme. These currently cost £3.05 pe week and the full State pension is £175.20 per week.
It is understandable that the last thing on the mind of the newly self-employed is planning for retirement. In the early days survival and building the business are the focus. This year many established businesses have faced months of closure which may have set back plans to save for retirement. However, neglecting pension saving can be a costly mistake leaving less time to catch up. That may mean working longer or adjusting living standards in retirement.
The system of tax relief for pension savings offers some flexibility, especially important for the self-employed. Tax relief is granted on pension savings of up to 100% of self-employed profits with a ceiling on savings of £40,000* per tax year. Allowances not claimed in the tax year profits are earned can be carried forward for up to 3 tax years, with catch up pension savings receiving that relief in the year they are paid into the pension plan. This can be an ideal option for the new start up, where earnings in the early years may be lower and less certain. If the business is successful, a catch-up pension payment can recoup the tax relief foregone in the earlier years.
Devil In The Detail
However, one little known rule is that the ability to carry forward tax relief to future years can only be used by those who have a registered pension scheme in place in those earlier years. If the individual has no pension scheme open to receive contributions, they lose the relief from the earlier year’s profits.
A second rule, which restricts the relief available to those with taxable income in excess of £240,000 per year can also limit catching up on pension savings with the benefit of tax relief. *Higher earners have a restricted annual allowance for pension savings. For the tax years up to 2019-20 the £40,000 allowance starts to reduce once income is over £150,000. From 2020-21 this threshold was increased to £240,000.
How these two obscure rules can affect retirement planning is illustrated in the case study below.
A Tale of Two Partners
Fiona and Joe, partners in an interior decorating business, each earned profits of £15k, £35k, £100k and £300k each in the first four years of trading. Joe had a pension plan from his previous employment which could still receive contributions. Fiona had no pension plan.
Following their bumper year both were looking for tax efficient ways to save their surplus income. Because Joe had his pension plan open, he was entitled to relief on total contributions of £100,000. Fiona could only pay in £10,000 for the current year, with no carry forward of relief. Not only was Fiona restricted in how much she could save in a tax -exempt pension pot but she also had a tax bill to pay that was £40,500 greater than Joe’s, even though their profits were the same.
Having a pension plan in place in the early years of self -employment can leave options open for later years. Getting started sooner will also enable the timing of retirement to be a choice, rather than a necessity. Pension plans can be opened with as little as £25 per month or a one-off sum of £400, so having a plan open, even if you cannot afford to pay much in to start with, can be a good investment for the future.
The contents of this blog are for information purposes only and do not constitute individual advice.
Director of Public Policy, LEBC
Please remember, no news or research item is a recommendation or advice to buy. LEBC Group Ltd is not responsible for accuracy and may not share the author’s views. If you are unsure of the suitability of any investment or product for your circumstances please contact an adviser. All investments can fall as well as rise in value so you could get back less than you invest. The Financial Conduct Authority does not regulate tax planning. Tax rates and allowances may change in future.