Life after work: the ins and outs of contractor pensions

While over 50% of contractors now pay into a pension — up from just 36% in 2018 — we still lag behind employees. Not only are the latter saving more and sooner, but research suggests that the 50% of contractors who aren’t saving for retirement are either delaying or in denial about needing to do it.

As it happens, setting up a contractor pension is neither complicated, nor does it require as much effort as you’d think. Plus, alongside securing your future, you’ll also get the benefit of tax savings today.

So how do you go about setting up a pension as a contractor? How much should you save? And what’s the most tax-efficient way to pay into it?

This guide has been updated for 2023/4.

Why save into a contractor pension?

There are two compelling reasons to pay into a contractor pension. Firstly, to afford a better retirement. And, secondly, because it’s one of the few remaining tax breaks you can benefit from when you’re self-employed.

The current state pension is £203.85 a week, or £10,600.20 a year (2023/4). Even if you’ve paid off your mortgage, that’s barely enough for utilities, groceries, and other necessities, let alone the cost of hobbies, entertainment, and the other activities that make retirement worthwhile and fulfilling.

Back in 2019, the Pensions and Lifetime Savings Association estimated that you need at least £10,200 a year if you’re single and £15,700 as a couple to cover your bills and afford to have some fun. For most contractors, these sums will be much higher.

Saving into a pension will help ensure you not only make up the shortfall, but have more saved up to spend on what brings you joy.

At the same time, what you pay into your pension is tax-deductible.

How the deduction works — and how much you can shave off your tax bill — depends on whether you pay into the pension personally or through your limited company (more on this in a minute). But the bottom line is that you’ll pay less tax. This holds true whether you do business through your own limited company, use an umbrella company, or are within IR35’s scope.

Auto-enrolment and contractors

Before we dive into the nitty gritty of setting up a pension (and the tax implications), it’s worth noting that as a contractor working through your own limited company, you’re exempt from auto-enrolment.

Auto-enrolment requires employers and employees to pay into a workplace pension if the employee is:

  • Aged between 22 and state pension age
  • Earns £10,000 a year or more
  • Usually works in the UK and has an employment contract

If you’re your company’s sole director and you’ve no other employees — or if there are other directors but no employees and none of you have an employment contract — the Pension Regulator doesn’t consider you an employer. And this is why you can get an exemption.

The exemption is not automatic. You’ll need to tell the Pensions Regulator you’re exempt. If you don’t, you’ll need to set up a workplace pension and both you and your company will have to contribute as follows:

  • Your company contributes 3% of your “qualifying earnings” — your total annual income excluding dividends
  • You pay 5% of your “qualifying earnings”

These amounts are the minimum you must pay in. Nothing stops you from paying more into your pension.

The flipside is that a workplace pension isn’t very flexible. You’ll have to pay at least the minimum every month, even if you’re not working. You’ll also have less choice, because your pension must be a workplace scheme.

For this reason, it’s worth getting the exemption and setting up your own pension.

Auto-enrolment, umbrella companies, and IR35

The situation is slightly different if you work through an umbrella company or are within IR35’s scope.

The Pensions Regulator considers umbrella companies to be employers and you’re considered an employee. So if you meet the other criteria — age, income threshold, you work mainly in the UK, and have an employment contract — you must be enrolled. That said, you can opt out and set up your own personal pension.

By contrast, HMRC has been clear that, if you fall within IR35’s scope, the client doesn’t have to enrol you into their workplace pension. This puts you in the same situation as other contractors who work through their own limited companies but are outside IR35’s scope.

Read our quick guide to pension contributions via an umbrella company.

What’s the most tax-efficient way to pay into a pension?

HMRC treats pension contributions differently, depending on whether you make them from your own personal funds or through your limited company.

As a rule, if you contract through your own limited company, it’s more tax-efficient for the limited company to make the contributions, for the reasons we’ll get into shortly.

By contrast, if you use an umbrella company, it might be best to pay via auto enrolment. This is because you’ll get the tax benefits of paying from your personal funds, plus additional contributions from the umbrella company on top.

That said, bear in mind that the umbrella company may charge a fee to cover the administrative cost involved in setting up and maintaining the workplace pension.

Contributing to your pension personally

When you pay into a pension from your personal funds, the government pays tax relief into your pension at your marginal rate.

Let’s say you pay £100 into your pension. The highest rate of tax you pay is 20%.

In this case, the government would add an extra £20 to your pot, bringing your total contribution to £120.

Similarly, if your highest tax rate is 40% and you pay £100, the government would throw in another £40, bringing your total contribution to £140.

Tax relief only applies up to 100% of your salary or £60,000 a year, whichever is the lowest. And you’ll have to pay tax at your marginal rate on any contributions over the limit.

So if you pay yourself a salary of £8,000 a year and take the rest of your income as dividends, for instance, you can only get tax relief on contributions up to £8,000 in one tax year. Anything over this amount will get taxed at 20%.

And if your annual salary is £75,000, you’ll only get tax relief on contributions up to £60,000 in one tax year.

The £60,000 limit will also go down if your ‘threshold income’ exceeds £200,000 a year or your “adjusted income” exceeds £260,000 a year.

Adjusted income is your taxable income plus your pension contributions, including tax relief. Threshold income is your adjusted income minus your pension contributions.

Paying through your limited company

Tax relief doesn’t apply if you pay into a pension through your limited company.

That said, any contribution your limited company makes is an allowable expense. So, while the government won’t pay extra money into your pension at your marginal rate, you’ll save corporation tax.

Crucially, while the £60,000 yearly limit applies to company pension contributions, the salary threshold doesn’t.

If, like most contractors, you take a small salary and the bulk of your income as dividends, this is a huge advantage. You get to save on income tax, national insurance, and corporation tax, and you can still set aside up to £60,000 a year for your retirement.

You can also carry over any unused part of your annual allowance from the previous three years, as long as you already had a pension set up and the company made at least as much profit as the amount you want to contribute.

How to choose the right contractor pension

Most personal pensions are ‘defined contribution schemes’. This means that how much you’ll get at retirement will depend on:

  • How much you’ve contributed
  • How long you’ve contributed
  • How the investments the pension scheme put your money into have performed

But while most personal pensions work in a similar way, not all are suitable for contractors.

So what should you consider when picking a pension scheme as a contractor?

Four things:

  • Flexibility
  • A strong reputation
  • A transparent fee structure
  • Whether you can consolidate

Flexibility is key

As a contractor, your income will fluctuate from month to month. So it’s worth going with a pension that will allow you to increase, decrease, or even stop your contributions altogether while you’re not working. If your scheme requires you to always meet a minimum contribution, it may become hard to keep up.

More to the point, you might not work through the same legal structure throughout the course of your career. Perhaps you might start out working through your limited company but decide to switch to an umbrella company for whatever reason.

A good pension plan will allow you to switch between making contributions from your limited company and making them personally.

A good reputation

The money you contribute to a pension is invested. If it’s managed well, this will make your contributions grow. But if it’s mismanaged, you risk not only not growing your investment, but also losing what you’ve contributed in the first place.

With this in mind, it’s important to make sure you invest with a strong, trusted institution. Your future well-being depends on it.

What does the scheme’s fee structure look like?

Schemes should give you a breakdown of what they charge on request. This will allow you to compare different schemes’ fees.

Most schemes take a percentage of the value of your pension pot every year, which means their income is tied to your investment’s performance. But some also levy other charges.

Avoid schemes that charge fees upfront. These fees are typically taken from your contribution, which means you’ll be effectively investing less.

The benefits of consolidating your pension pots

If you were employed before starting your contracting business — or you’ve switched umbrella companies — you may have several pension plans, some of which you might have even forgotten about.

Consolidating your pensions into one:

  • Makes it easier to manage your retirement savings, because they’re all in one place
  • Allows you to make sure all your money is in funds that match your risk appetite and beliefs — great if, for instance, you feel strongly that you shouldn’t support industries that harm the planet or have unethical employment practices
  • Can help cut costs. This is because you’ll pay one single fee instead of different rates or fee structures on different pots

It’s never too early to start saving for retirement

With the basic state pension so low that living on it is unrealistic, it’s never been more important to invest in a personal pension.

Retirement might seem like a long way away, but you’d be surprised at how fast time flies. Setting money aside for it today will help you make sure you can enjoy it to the fullest when the time arrives.

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    Please use this article as a guide only. You should seek professional advice while evaluating your pension options.

    Last updated: 7th May 2023