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Outside IR35 and no pension? Get tax savings with a pension

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 reduce your tax liabilities and, depending on your level of earnings, gain up to 50% tax relief by diverting your gross fee income into a pension. Here is how it works.

What you can save?

If you are contracting outside IR35, you will be trading via a limited company and are paying yourself a low salary and the rest in dividends.

Everything changed for pensions funding since the so-called 'A Day' in April 2006 when the regime was vastly liberalised. Pensions reforms announced in 2014 introduced further freedoms on how contractors can use their pensions savings.

Contractors outside IR35 can now make company contributions to a pension of up to £40,000 per year, with a lifetime allowance of £1 million.

So, whilst there are no further National Insurance Contributions (NICs) savings with pensions, as there are 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.

Contractors outside IR35 can now make company contributions to a pension of up to £40,000 per year, with a lifetime allowance of £1 million

Remember, any money invested in a pension goes in before these taxes are applied, offering significant 'tax relief'.

An example:

You have £100 worth of company income, and you are a higher rate tax payer, not caught by IR35. You can either put the £100 into a pension, or you can declare it as profit and take it as a dividend.

But if you choose the latter option and take a dividend payment, you pay:

  1. £20 in corporate tax on your £100, leaving £80
  2. 25% personal income tax on the net dividend, which takes another £20
  3. Your total take home is £60.

Choosing the pensions option means that the whole £100 goes into a pension fund and then has an opportunity to grow in a tax efficient environment.

In reality £25 of your contribution represents the part of the pension fund which you can draw tax free when you retire. £35 of your money also goes into the pension fund, together with the £40 that would have gone to the taxman. This £75 can also grow and withdrawn at a later date, or used to buy an annuity.

For contractors earning over £150,000 per year the tax saving is even more due to the 45% higher rate of tax. And for those earning between £100,000 and £120,000 per year the effective tax rate is 60% due to the reduction in personal allowances introduced. For high earners pensions are now an even more attractive option for tax savings than ever before.

You can calculate your own potential savings using the Contractor Pension Calculator.

Some quick facts about pensions:

  1. Contractors can invest up to £40,000 each year without any additional tax implications, up to a lifetime allowance of £1m
  2. Pensions are no longer about saving money to buy an annuity. Contractors can draw down on their pension funds from age 55 following new rules announced in 2014 that enable contractors to take multiple lump sums direct from their pension fund.
  3. A contractor’s pension savings can be passed onto their family if they die before age 75 - provided you've not bought an annuity.
  4. A contractor’s pension savings are perfectly safe as pensions funds cannot become insolvent. A private pension fund is carefully protected by law.
  5. If a contractor is risk adverse and concerned about funds invested in the stock market, they can choose to keep their pension pot in cash - just like an ISA.

Pensions are certainly no longer the rigid investments they used to be.

You can find out more by reading Pensions for Contractors - An Overview.

Updated: Wednesday, 15 April 2015

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