Saving for your future retirement can be more complex for the self-employed compared to those in traditional employment, but the government offers several tax benefits that make paying into your pension pot an attractive endeavour. So, what are the tax advantages associated with pensions for the self-employed?
Tax Relief
One of the most significant benefits of contributing to a pension is the tax relief offered by the government. When you pay into your pension, you receive basic-rate tax relief. This means the government boosts your contributions by 25%. For example, if you pay in £80, the government adds £20, making your total contribution £100.
If you are a higher or additional rate taxpayer, you can claim back even more tax relief on your self-assessment tax return, although there are limits on how much you can pay into your pension and receive tax relief.
Tax-Free Growth
Pensions, like ISAs, provide a tax-efficient environment for your investments. Within a pension, your money grows free from income tax and capital gains tax, regardless of how much your investments increase in value. This tax-free growth can significantly enhance the amount of money you have available at retirement.
Access 25% Tax-Free in Later Life
From the age of 55 (rising to 57 in 2028), you can start accessing your pension savings. One of the appealing aspects is that you can take 25% of your pension pot as a tax-free lump sum. The remaining 75% can be taken as income, which will be subject to income tax at your marginal rate. This flexibility allows for strategic planning of your retirement income to maximise tax efficiency.
Business Profits and Pension Contributions
Self-employed individuals and business owners can benefit significantly by paying business profits directly into their pensions. Contributions made as employer contributions from your business profits no longer count as profits, reducing your business’s corporation tax liability. Additionally, by not taking these profits as income, you also lower your personal income tax liability.
Contribution Limits
The amount you can pay into your pension depends on your earnings and tax bracket. Each tax year, you can typically contribute up to 100% of your earnings, including any tax relief, up to £60,000. This limit, known as the ‘annual allowance,’ applies to all contributions made to your pension, whether by you or your company.
However, your annual allowance may be lower if your earnings exceed £260,000 a year or if you have already taken an income from your pension plan. For the self-employed, ‘earnings’ are defined as the profits minus costs and expenses reported on your self-assessment tax return. Most earned income is included, but dividends and most types of rental income are not.
Employer Contributions
If your business operates as a limited company, you can make employer contributions to your pension. These contributions are deducted from your total profits, reducing your corporation tax liability. Moreover, employer contributions are not subject to employer’s National Insurance (up to 13.8%), making them even more tax-efficient. Since it is an employer contribution, you won’t be liable for income tax or National Insurance as an employee.
It’s important to note that employer contributions also count towards your annual allowance. Balancing contributions to maximise tax efficiency requires careful planning, especially for higher earners or those nearing retirement.
The Tax Benefits of Pensions
Pensions offer a range of tax benefits for the self-employed. The tax relief on contributions, tax-free growth of investments, ability to take 25% tax-free in later life, and the potential to reduce business profits and personal income tax through employer contributions all contribute to the appeal of pensions.
By utilising these tax advantages, self-employed individuals can build a robust retirement fund, ensuring financial security in later life. Whether you are just starting your self-employment journey or are well-established, considering a pension plan can provide significant long-term benefits.
For further help and advice on pensions for the self-employed, contact DabHand Accounting today.
