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 do not benefit from an employer payment into a pension automatically set up for them. From April employers have to pay in 2% of eligible employees qualifying earnings to a pension fund and this will rise to 3% in April 2019. The self employed have to find and fund their own pension arrangements.
Historically the self employed have also missed out on the additional component of the State pension scheme which existed until 2016 and could almost double the basic state pension of employees, if sufficient national insurance contributions had been paid in by them and their employers. Self employed workers may only expect the basic State pension for credits earned up to 2016, leaving another gap in their retirement funding.
From 2016 the State pension changed. The basic state pension is augmented by an additional pension, which is no longer exclusively for the employed, nor is it earnings related. This means that for the first time, the self employed can earn the same state pension as the employed and all workers who pay national insurance will build up the same entitlement to a State pension from April 2016 onwards of up to £159.55 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. However, neglecting pension provision can be a costly mistake as delaying starting paying into a pension can mean that the individual runs out of time to catch up.
The system of tax relief for pension savings recognises that all workers, the self employed in particular, need more flexibility over the timing and amounts they pay into their pensions. So, relief not used up in the tax year it is earned can be carried forward for up to 3 tax years, with catch up pension investments then receiving relief in the year of payment. 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 investment can recoup the tax relief foregone in the early years.
However, one little known rule of the pension savings tax regime 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 cannot carry forward the relief from the earlier years. So unless there is a pension plan in place entitlement to relief not used in the year it is earned is lost.
A second rule, which restricts the relief available to those with taxable income in excess of £150,000, can also limit the ability to save into pensions, with the benefit of tax relief later on. How these two obscure rules can affect future retirement planning is illustrated in the case study below.
Fiona and Joe earned profits of £15k, £35k, £90k and then £210k each in the first four years of trading from their interior decorating business.
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 in place he was entitled to relief on total contributions of £100,000 whereas Fiona could only pay in £10,000 for the current year with no carry forward. Not only was Fiona restricted in how much she could save in a tax exempt pension fund but she also had a tax bill to pay that was £41,100 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 option of earlier or later 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, it can be a good investment for the future.
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.