How pensions work for contractors

One thing is sure: when you earn income as a contractor, you have to pay tax on it. Unless of course you use your contractor income to make payments into a pension fund.

Tax or pension?

If you are a PAYE contractor you pay full NI and PAYE on that income before you see any cash for yourself. If you work through a limited company and are outside IR35 you first pay Corporation Tax on the company profits, and then take a dividend – which is subject to personal income tax.

These taxes can take away a considerable portion of your income. For higher rate tax payers you could be looking at marginal rates of tax of up to 48%.

But suppose you don't put the money in your pocket now. Suppose that, by making pension fund payments now and waiting until you are of retirement age (currently 50, moving to 55 by April 2010), you don’t pay any taxes on it at all now - you can invest the entire amount.

Pension investments enjoy significant tax breaks because the government wishes to offer us incentives to save for our retirement. In recent years thousands of contractors have been able to receive millions in tax relief.

However, since changes to the pension rules following the budget in April 2009, contractors who earn over £130,000 are capped in the amount of pension contributions they can make tax free.

At retirement

When you retire, if you wish, you can take 25% of the money as a lump sum – completely tax free. With the rest of the money there are various options:

• Skimming: you can take income from your fund based on specific limits each year relative to the size of the fund, leaving the remaining fund invested for future growth
• Annuities: You must purchase these at age 75, but you need not before that age
• Inheritance: You can leave your pension to your heirs--it is not subject to inheritance tax if you die before you retire

(If you die after retirement age, but before you take an annuity, you can still leave the funds to your heirs but there are taxes to pay.)

Tax relief for both higher and lower rate brackets

'''Since Pensions simplification in 2006 and further clarification in 2007, pensions are a lot easier to work with,'' says Tony Harris, chief executive of the Richmond, Surrey-based ContractorFinancials, which specialises in contractor affairs. There is now just one set of tax rules for all types of pension, with an individual Lifetime Allowance (£1.75 million).''

The marginal tax rate is the percentage of tax you pay on the last bit of income you earn. For example, if you are a higher rate tax payer using an umbrella company you pay £48 tax on every £100 you earn. This is because you pay employers NI, employees NI, and Income Tax.

If instead you put the £100 in a pension, you may consider that you are getting 48% tax relief. ''Tax relief'' is the percentage of tax you have not paid because you have decided to invest in a pension.

For contractors using limited companies, also in the higher rate tax bracket but not caught by IR35, the tax relief is approximately 40%. So, instead of paying £40 tax and taking £60 as net income, you can invest the full £100 in a pension, thus obtaining 40% tax relief.

For contractors who are not higher rate tax payers there are still large tax benefits to be achieved, because you avoid tax at the lower corporation tax bracket of 21%.

How much can you invest?

The rules governing pensions investment no longer fix a percentage of salary for investment. Now contractors can place up to 100% of their contract income into a pension. In addition the rules regarding funding a pension scheme direct from your limited company (or contractor umbrella provider) allow a massive investment of up to £245,000 per annum without regard to the amount of your earnings up to £130,000, after which new rules kick-in. Company investment is the most lucrative method from a tax perspective.

So, you can put as much tax-free money as you want to into your pension fund. You just have to pick the one that's right for you. You'll take 25% tax-free and then may pay some tax on the rest of it when you access it at age 55 (or 50), but the tax will be probably be much lower than what you would have paid on it as income when you were younger. What you leave in the fund to grow remains tax free.

What can you invest In?

You can invest in a variety of funds, and divide up your portfolio into investments with varying degrees of risk. Or if you aren’t a fan of the stock market, you can hold it all in cash and simply earn interest as you would with an ISA

You can even add commercial property investments to your pension. Buy an office or a shop, and put the revenue from it into your pension. We'd hoped residential property would be included but at least we've come this far.

Your options at age 50 (or 55 after April 2010)

You may, if you choose, start enjoying pension benefits from the age of 50, but from 2010, this will rise to 55. Nonetheless, you will have access to your money at a relatively young age and lots of time to enjoy it. You can take 25% of your money in a tax-free lump at this age (or later if you wish). It doesn't matter whether or not you have actually retired or are still working.

After age 50 there are a few options:

• Leave the money in the fund where it continues to enjoy the potential to grow tax efficiently
• Take a lump sum of 25% tax-free
• Skim some money out of the fund each year as an income
• Buy an anuity to provide income

At age 75

At age 75, you must use your pension funds to buy an annuity, or enter something called an alternatively secured pension.

An annuity is a policy that provides a regular income in exchange for a lump sum. It's not a high rate-paying investment and usually returns around 5%.

But it does ensure you a regular income as you mature. You should explore other tax and inheritance options at that point with an accountant or tax lawyer, but you will have many more lower-tax possibilities thanks to your pension investment.

Contributions cap for contractors who earn more than £130,000 per year

New rules that came into force following the April 2009 Budget mean that contractors who earn over £180,000 per year will have their tax relief capped at the basic rate of 20%, with contractors earning between £130,000 and £180,000 per year receiving relief on a sliding scale of between 20% and 40%.

Contractors who have earned £130,000 or more this year, or over the past 2 tax years, will only receive 20% tax relief on their pension contributions above a ‘special annual allowance’ of only £20,000, which includes contributions from the contractor’s net earnings and their limited company.

Contractors who made regular pension contributions will be able to continue with the contributions as ‘protected input amounts’. For example, a contractor who has regularly contributed £3,000 per month can continue to enjoy 40% tax relief, even if they are earning over £130,000 per year.

Unfortunately, contractors who have made irregular contributions and those investing a lump sum each year won’t qualify for this benefit, and will only be able to gain full relief up to a maximum of £30,000 contribution. Contractors tempted to switch pension providers will lose their ‘protected input amount’ benefits altogether. Gift aid, and other certain personal investments may be used to reduce your income below this £130,000 cap.

Given that nothing is certain but death and taxes, contractors should consider pensions as a way of taking the sting out of the latter, even for those contractors earning over £150,000 per year.

Updated Tuesday, April 07, 2009, [Originally published Monday, June 16, 2008]

© 2010 All rights reserved. Reproduction in whole or in part without permission is prohibited.