When starting a business, often retirement is the last thing on your mind. We are all told to save for the future, but starting a business can be expensive, time consuming and a financially uncomfortable period.
Making the jump to self-employment comes with many advantages: control over your time, ability to make decisions for yourself and the freedom to choose the work you do, to name a few. Lesser spoken about are the downsides of self-employment. Lack of holiday or sick pay, no company pension scheme and most importantly, no stability of income can be daunting to an individual who relies on their income to feed themselves and their family!
In the beginning, the focus should of course be on creating financial security for the business itself and to provide you with an income that allows you to sustain the quality of life you strive for. However, what happens once your business is up and running and producing enough to support you today?
Pensions can be a useful tool for many financial planning reasons. The most common being to save for retirement.
For those in full time employment, most people are auto enrolled into a workplace pension. The minimum requirement of auto enrollment is for the employer to pay 3% of your total earnings between £6,240 and £50,000, and for you to pay 5%. Employee contributions receive tax relief from the government of 20% into the pension scheme.
For the self employed, there is no law enforcing that you pay into a pension scheme and it is easy to forget to do!
Here are some of the benefits of paying money into a pension scheme:
Sole traders and Partnerships: Contributions receive tax relief
When a contribution is made to a pension by a sole trader or partner, the contribution is treated in the same way as an employee contribution.
This means that when a contribution is made, the government tops up that contribution with 20% tax relief.
For example, if you make a contribution of £16,000 to your pension in a tax year, the government tops this up by £4,000! Yes you heard that correctly – an additional £4,000 is added to your pension savings from the government.
Pension rules state that contributions are subject to a maximum annual contribution of the persons gross annual earnings, or £40,000 (whichever is higher), including the tax relief.
For someone who has no income, the maximum annual contribution into a pension is £2,880. This still receives tax relief of £720 making the total contribution £3,600.
Directors of LTD companies: Contributions can be offset against Corporation Tax
If you are a director of a limited company, rather than making personal contributions to a pension, you may choose to make employer contributions into your pension scheme.
This can be a valuable tool in moving the wealth from one entity, the company, into your pocket without paying immediate income tax on the amount paid to the pension.
Contributions paid this way are treated as valid business expenses by HMRC, which means that the amount you pay into the pension will be offset against your corporation tax bill for that year.
Child benefit threshold
If you have a child or children, and earn less than £50,000 per year, you’re usually eligible to receive child benefit. Once one person in the child’s household’s income increases above £50,000, the amount of child benefit the family is eligible for decreases by £1 for every £2 over the £50,000 limit.
This means that if one person in a family earns more than £60,000, the family will not be entitled to child benefit and may need to pay any child benefit received back.
For those whose income creeps around the £50,000 – £60,000 per year mark, making a pension contribution has the effect of reducing the taxable income.
So, for example, if someone earned £52,000 per year, making a personal pension contribution of £2,000 (including the tax relief) would bring their earnings back down to £50,000. They would then be entitled to the full child benefit amount again.
Tax free growth of the investments within a pension
A pension is an example of a tax efficient wrapper. This means that money held within the pension wrapper is outside the reach of the tax man! Any growth made on investments within a pension is not subjected to Capital Gains Tax, and any income received by the pension scheme does not attract an income tax.
Please note, that these rules apply to the money when it is inside the pension. Different tax rules apply when you take money out of a pension.
To put this into perspective, if you invest £16,000 into a pension, the government adds £4,000 tax relief making £20,000. If this £20,000 was invested and increased in value over time, no tax is payable when the investment is sold, as long as the sale proceeds remain within the pension wrapper.
Benefits on Death
Although not the most upbeat topics of conversations, there is often a benefit to holding money in pensions on your death. Those benefits depend based on how old you are at the date of death.
For most pension schemes, if the holder dies before the age of 75, the value of that pension can be passed to the beneficiaries of the pension holders choosing completely tax free.
Naturally, there are some regulations around this, and it will be dependent on the pension being valued less than the pension Lifetime Allowance, and this doesn’t include the final salary or career average style pensions.
If the holder dies after the age of 75, the value of the pension can still be passed to loved ones, however it will be taxable as income to the person who receives it.
Pensions are outside the estate for Inheritance Tax and Bankruptcy proceedings
Those with larger estates (or pension schemes!) will be pleased to hear that most pensions are disregarded when it comes to calculating how much Inheritance Tax is due to be paid on death.
This is because pensions are usually held under trust for the individual and therefore the pension is not considered inside the deceased persons estate.
The same applies in the event of a person becoming bankrupt. Unless significant contributions have been made immediately prior to an individual becoming insolvent or bankrupt, the individuals pension is not considered as an asset that the Trustee in Bankruptcy becomes responsible for. Unless an individual is already drawing income from their pension, a pension can not be used to clear a bankrupts liabilities.
Summary
To summarise, there any many benefits to saving into a pension scheme. A pension can be a really tax efficient tool for moving wealth from your business to your pocket, whilst ensuring that your hard earned money remains for the benefit of you and your family or loved ones, even after your death.
Pensions can currently be accessed after the age of 55, however this is set to increase over time. Current legislation proposes that the minimum age to access pensions will increase in line with rises to the state pension age, where private pensions can be accessed 10 years before the state pension.
For example, if your state pension age is 67, you will be able to access private pensions from the age of 57. Rules differ in the event of terminal illness or serious ill health.
If you would like to discuss your pension contributions in more detail, or would like advice on how to start saving for your future, you can contact Becky on 07500 776229.