When it comes to saving taxes, Limited Company contractors have many options. Out of all the tax-saving options, one of the most beneficial methods is by investing in a pension. Along with tax savings, pensions also help in building funds for retirement. In this article of "Path of Education for New Contractors" we look at pensions in detail.
Limited Company contractors can withdraw money either as a salary or as a dividend. Salary is not a very effective method from a tax saving point of view. That's because you have to pay income tax and National Insurance contributions if your salary exceeds the allowed limits.
Compared to a salary, dividends are a more tax-efficient method as there are no National Insurance contributions on dividend. However, you need to pay income tax on any dividends received. But the income tax on dividends is lower when compared to salary, thanks to the dividend tax credit.
Apart from dividends, another very effective method of saving taxes is by investing your earnings in a pension fund.
Example 1: Suppose you have made a profit of £60,000. On this profit, you will have to pay Corporation Tax of 20% (£12,000), and you will be left with £48,000 (£60,000-£12,000). Let's assume you've already paid a nominal salary to yourself, which is below the threshold of personal income tax and National Insurance contributions. Out of this profit, you declare a dividend of £45,000, which works out to a gross dividend of £50,000. Your tax liability on this amount will be £1,831, leaving you with a take-home pay of £43,169. So in total, you will have to pay tax of £13,831 (£12,000 + £1,831).
However, if you divert, say, £40,000 to pension, you have to pay Corporation Tax only on £20,000, which works out to £4,000. You don't have to pay personal income tax or National Insurance on the £40,000 invested in pension. This way, you can get tax savings of £9,831 (£13,831 - £4,000).
You are allowed to invest up to £40,000 each year into a pension, before tax deductions are incurred. If you invest more than the annual allowance of £40,000, you won't be getting any tax benefit for the excess amount. You can carry forward any unused allowances for up to three years. This rule helps contractors, as it takes care of any inconsistencies in earnings.
Example 2: In 2014, suppose you make pension investments of only £20,000, even though you are allowed to save £40,000. Then, in 2015, you have a good year in business, and you would like to invest more in pension. In such an event, you can carry forward the unused £20,000 of the previous year into the next year and put £60,000 (£20,000 + £40,000) into a pension.
Note that even with unused allowances, you cannot put more money into a pension than what you have earned in a particular year.
Example 2: Let's say in a year you are left with unused pension allowances of £80,000. However, your income or profit in the year is only £50,000. You cannot invest more than £50,000 in pension.
And finally, you are not allowed to invest more than £1.25 million (from April 2014) in pension in your lifetime.
One advantage of being a Limited Company contractor is that you can choose where your pension money is invested. Unlike full-time employees, who may be dependent on their employer's choice of investments, Limited Company contractors have a choice when it comes to investment of pension funds.
Depending on your risk profile and expectations for returns, you can choose any of the following options.
You can also choose a pension fund that invests in a mix of some or all of the assets mentioned above. This way you can spread the risks and also get some stability. If you are financially savvy, you can even divide your pension savings into different types of pension funds, say 50% in equity funds, 20% in bond funds and so on.
Certain types of pensions such as self-invested personal pensions or SIPPs allow the use of your pension funds for buying commercial property or office space for own business. Of course, your pension fund should have enough money to afford this purchase, but the rent on such a property can be an excellent source of retirement income.
With so many options, it can be difficult to choose an appropriate pension fund, which is suited to your needs. Let's look at the factors you need to consider before finalising a pension fund.
Pension funds are available to you upon reaching the age of 55. Of the total pension savings, you can withdraw 25% without any tax. Let's look at what you can do with the remainder 75% of funds.
Full Withdrawal: As per the new rules announced in 2014, you can withdraw the entire pension pot once you reach the age of 55. As mentioned above, 25% of this amount will be tax-free, and the remaining 75% will be taxed as per marginal tax rates. The new rules come into effect from April 2015.
Drawdown or unsecured pension: Under this scheme, you can transfer 75% of your pension savings into an income drawdown scheme. The money will be invested in different investments, which provide a combination of growth and stable income. Note that drawdown or unsecured pension is a risky option as the returns are linked to the stock market, and there is no guarantee of fixed returns.
Annuities: You can use your pension savings to purchase annuities, which will provide you with a secure income until death. When compared to drawdown, annuities are a less risky option and provide a limited scope of growth.
Inheritance: You can pass on the pension pot to your family members. The new pension rules have made this option very attractive thanks to the abolishment of 55% 'death tax,' which was earlier applicable to inheritors on withdrawal of pension funds. Upon withdrawal, pension funds inheritors will be taxed at their marginal tax rates.
Pensions are an excellent option for saving tax. Apart from taxes, pensions are very important for Limited Company contractors as they are responsible for their own retirement. A recent study by Resolution Foundation showed that more than two-thirds of self-employed people are not investing at all in pension. Full-time employees are automatically covered in a pension through their employers. But self-employed contractors do not have any such advantage, and they face the risk of not having enough retirement savings.
While investing in pensions, you should choose a fund and the investment portfolio with care as these can play a big role in both the safety and the performance of the investments. If you are looking for assistance on setting up a pension scheme, it is of value to consider the pension services of Contractor Financials.