If you are contracting and don’t have a pension, you are missing out on significant tax savings, even if you aren't caught by IR35?
Why? Because you can avoid lots of taxes by diverting your income into a pension. Here's how it works...
What can be saved?
If you are contracting outside IR35 you probably have a limited company and are paying yourself a low salary and the rest in dividends. Because of your low salary, this meant in the past that you couldn't put more than £300 per month into a pension due to age related allowances. But everything changed for pensions funding since the so-called 'A Day' in April 2006 when the regime was vastly liberalised.
Contractors outside IR35 can now make company contributions to a pension of up to £245,000 per year, with a lifetime allowance of £1.75 million.
So, whilst there are no further N.I. tax savings with pensions (as for contractors inside IR35) there are still large savings to be made by avoiding corporation tax, and income tax, particularly for higher rate tax payers. Remember, any money invested in a pension goes in before these taxes are applied, offering significant 'tax relief'.
An example:
For a contractor outside IR35 earning £40 per hour, each £100 earned attracts £39 tax with only £61 ending up in their pocket.
Instead of drawing £100 as income the whole £100 could be contributed to a pension. This reduces net income by £61, but increases a pension by £100, attracting tax relief of 39%.
You can calculate your own potential savings using the Contractor Pension Calculator.
Some Quick Facts About Pensions
- Pensions aren't all about saving money to buy an annuity. You can withdraw 25% of your pension funds tax-free from age 50. And rather than buying an annuity, you can continue to draw from the funds each year to maximum limits.
- Your savings can be passed on to your family if you die before age 75 - provided you've not bought an annuity. The money will not be subject to inheritance tax.
- You no longer pay large portions of your payments in commissions to an IFA - charges are negligible - comparable to buying a tracker fund.
- Your funds are perfectly safe as pensions funds cannot become insolvent. A private pension fund is carefully protected by law.
- If you're risk adverse and concerned about funds invested in the stock market you can option for keeping the pot in cash - just like an ISA.
Pensions are certainly no longer the rigid investments they used to be.
However, contractors earning over £130,000 per year should beware, as changes to pension rules in the April 2009 budget penalises higher earners by capping tax relief on pension contributions.
You can find out more by reading Pensions for Contractors - An Overview.
Pension Quotation
Updated Tuesday, April 07, 2009, [Originally published Monday, December 06, 2004]
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