Pensions
Contractors in the UK often face unique challenges when planning for retirement. Unlike traditional employees, contractors must proactively manage their pension contributions since they lack the employer managed pensions typically provided to permanent staff.
The approach to pension contributions varies depending on whether you operate Inside IR35 via an umbrella company or Outside IR35 via a limited company. This guide explores the options available in each scenario, focusing on Self-Invested Personal Pensions (SIPPs) and workplace pensions while explaining methods of contributing’such as salary sacrifice and contributions from net pay. It also highlights the impact of these methods on Income Tax and National Insurance Contributions (NICs), providing recommendations for maximising your savings.
Inside IR35
When working Inside IR35, contractors are treated as employees for tax purposes. This means your income is processed as salary through an umbrella company, and deductions for Income Tax, NICs, and other expenses are made before you receive your net pay. Pension options in this situation include workplace pensions and SIPPs.
Workplace pensions
A workplace pension, also known as an auto-enrolment pension, is set up by an employer for its employees. Employees typically pay a percentage of their monthly salary into the scheme, with employers also contributing.
As your employer, umbrella companies must legally enrol you into a workplace pension. When you register with an umbrella company, they’ll send you information regarding pension auto-enrolment and their preferred pension provider. This is usually NEST, the Government’s workplace pension scheme.
The minimum contribution set by the Government that you can pay into your pension is 8%, split into 5% employee and 3% employer. It’s important to note that both the employee’s 5% and the employer’s 3% are deducted from assignment income. They are not an additional uplift, and the umbrella company does not contribute from its own funds.
Both employee and employer workplace pension contributions reduce taxable income, thereby reducing Income Tax owed. The employer element also reduces gross pay, thereby reducing both employer and employee National Insurance Contributions.
However, no National Insurance relief is given on the employee element. This makes workplace pensions less tax-efficient than salary sacrifice.
In addition, workplace pension schemes often come with high charges. Take the Government’s scheme, NEST, as an example. They charge 1.8% on every contribution and a 0.3% annual management fee. While the 0.3% fee is broadly in line with the industry average, the 1.8% contribution fee is steep. Plenty of Target Retirement Funds charge nothing to contribute and lower ongoing costs. See Vanguard’s Target Retirement as an example.
The Vanguard Target Retirement merely illustrates the high fees charged by workplace pensions; it is not advice or a recommendation to invest.
Self-Invested Personal Pension (SIPP)
A self-invested pension plan (‘SIPP’) is a type of personal pension that allows you to manage your investments or pay a chosen financial adviser to support you. Most contractors opt-out of workplace pensions in favour of salary sacrifice into a SIPP as it offers more control and greater tax relief.
Umbrella companies deduct salary sacrifice contributions from your gross pay; there is no additional burden for the contractor. Contributions also reduce both Income Tax and National Insurance, unlike a workplace pension, for which only the employer element reduces NI.
It is, therefore, the best option for those seeking to minimise their tax liabilities.
Not all umbrellas offer salary sacrifice due to the challenges of implementing it into their existing payroll software. If it interests you, always double-check before you register that your chosen provider can accommodate salary sacrifice. As this is an extra administrative burden for an umbrella company, it often comes with supplementary fees.
Outside IR35
When working Outside IR35, contractors typically operate through a limited company, allowing greater flexibility in how pension contributions are made. Pension contributions can either be paid directly by your company as an employer contribution or personally through your post-tax income.
Limited company employer contributions
For contractors using a limited company, the most tax-efficient way to contribute to a pension is through employer contributions. When your company makes a pension contribution on your behalf, it is treated as an allowable business expense. This reduces your company’s taxable profits, resulting in Corporation Tax savings. Currently, Corporation Tax rates range from 19% to 25%, depending on your profits.
Employer contributions are also exempt from Income Tax and NICs, allowing the entire amount to be invested in your pension.
For example, if your company contributes ??20,000 to your pension, this amount is fully tax-free for you and reduces your company’s taxable profit by the same amount. However, these contributions must comply with HMRC’s “wholly and exclusively” rule, meaning they must be reasonable in relation to your role within the company.
The flexibility of employer contributions makes this option particularly appealing. It allows you to make significant pension contributions without incurring personal tax liabilities, up to the annual allowance of ??60,000.
Workplace pensions
As a contractor working through a limited company, you can apply to the Pensions Regulator for an exemption if you’re the company’s only director and employee. If you don’t apply for the exemption, your company must set up a workplace pension and make employee and employer contributions on your behalf.
If the company has two or more directors, none may have an employment contract to qualify for the exemption. Therefore, if you currently employ your spouse via your limited company, you must register them with a workplace pension scheme, although they can opt out.
Due to the inflexible nature of workplace pension schemes, most limited company contractors choose to take the exemption and instead contribute via their SIPP. A much more flexible option.
Contributions from net pay
As a limited company contractor, you can pay into your SIPP from your after-tax earnings or directly from the company. If you make payments from your after-tax earnings, you get automatic tax relief at the basic rate of 20%; then you claim back the higher rate (40%) or additional rate (45%) relief via your self-assessment tax return.
If you make payments directly from your limited company, the contributions count as allowable business expenses, reducing the Corporation Tax you pay. You will also save on Employer’s National Insurance (something you can’t claim back if paying out of after-tax income) and Income Tax owed on the extra salary/dividend not taken.
Therefore, paying into your SIPP via your limited company is more tax-efficient than paying from your after-tax earnings.
Conclusion
Pension contributions are an essential aspect of financial planning for contractors. Whether you operate inside or Outside IR35, understanding your options and the tax implications of each method can help you maximise your retirement savings. By leveraging tax-efficient strategies such as salary sacrifice and employer contributions, you can secure a comfortable retirement while minimising your current tax liabilities. Take the time to review your pension options, consult a financial advisor if needed, and align your contributions with your overall financial goals.