Self-employed? Why it pays to start your pension now

The recent Pension Commission report contained some pretty staggering stats on the state of retirement saving in the UK.

Among them the revelation that just 4% of fully self-employed workers, or one in 25, are currently saving for retirement.

That puts a lot of the UK’s most driven workers at risk of a very uncomfortable future if their business can’t sustain them into retirement.

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The reasons why the self-employed don’t save are manifold. Self-employed people don’t have an employer that’s legally bound to provide a workplace pension scheme and pay into it on their behalf.

Then there’s the fact that self-employed income is notoriously “lumpy”, making it hard to work out how much you can afford to save from one month to the next.

But even without the benefits of employer contributions, pensions are still a super tax-effective way to save for life after work, with both upfront relief on contributions and tax-free growth.

Over time, that means any money you can spare for retirement will likely grow much faster in a pension, than other less tax-efficient savings and investment accounts.

The key is to make saving for retirement an integral part of your business.

Here’s how to do it.

1) Choose the right pension

A self-invested personal pension, or SIPP, that you can manage online is a great choice.

Unlike some of the workplace schemes you might have had access to, they’re really flexible.

You won’t be bound to a fixed contribution each month and can instead match them with your cash flow. And if ad hoc lump sums work better for you, then that’s fine too (although that might require a bit more discipline on your part).

SIPPs will also offer you access to a much wider choice of investments than pensions you may have had in the past. That includes funds, investments trusts and UK and overseas shares.

But it’s important not to pay over the odds for your SIPP and compare costs carefully.

Most platforms’ fees are based on a percentage of your pot – such as 0.35% – but interactive investor charges a flat-fee. This means that your charges don’t go up when your investments grow.

Although you can’t access your pot before you’re 55 (57 from 2028), a SIPP should give you full and flexible access to your savings when you start taking income.

Like other pensions, you can take 25% tax free, the rest will be subject to tax.

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2) Set up contributions – and get the top-ups you are entitled to

The next step is to work out how and when you’ll contribute to your pension. Regular payments are great as saving becomes automatic (you can stop and start contributions if you need to). However, lots of self-employed workers will pay in lump sums when finances allow, or as part of annual financial reviews.

You also need to understand how much you can contribute and the tax relief available.

Sole traders or partnerships

If you’re a sole trader or partner in a business, anything you pay into your pension will come from your personal income.

Each year you’ll be able to contribute 100% of your income, up to £60,000, and will get tax relief on your contributions that’s equivalent to the rate of tax you pay.

This top-up from the government effectively means it only costs basic-rate taxpayers £800 to invest £1,000 into their pension, while higher-rate taxpayers pay just £600 to invest that amount.

Just note that your SIPP will only apply basic rate (20%) relief automatically. If you pay higher or additional rate tax, you’ll need to claim the outstanding relief you’re entitled to in your tax return.

If you’ve had a bumper year, you may be able to pay more than £60,000 into your pension.

Carry forward rules let you pay any unused allowance from the previous three years into your pension this year. You just need to have been in a pension during those years and not pay in more than 100% of this year’s income.

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Limited company directors

If you run a limited company and are director, there’s another way to pay into your pension.

Rather than using your personal income to make pension contributions, you can make payments from your company’s pre-tax profits.

So, rather than getting tax relief on your contributions, these payments count as a business expense, which subsequently reduces the amount of corporation tax that you pay. Likewise, it will reduce your national insurance (NI) bill if you’d planned to draw those profits as salary.

Your contributions will still be capped at £60,000 a year, but unlike sole traders or partners, there’s no need to meet the 100% of income requirement (so long as they meet ‘wholly and exclusively’ requirements, that is, they’re reasonable).

Directors can benefit from carry forward too. That means, this year, they could potentially pay £240,000 into their pension (the current year’s allowance, plus three unused years).

Just note that while you’d make savings on your corporation tax bill, that money wouldn’t be applied to your pension.

Whether it makes most sense to make personal or company contributions will depend on your business and how you take profits from it – so it’s a good idea to get advice from a regulated financial adviser.

3) Choose investments

Next up, you need to choose where to invest your contributions; there’s no default option as there is with workplace pensions.

If you don’t want to spend time researching investments, or just don’t fancy it, you can pick a single one-stop, low-cost core holding – such as a multi-asset fund – that gives you all the diversification you need.

Or you can use a “managed portfolio” – run by your pension provider – that invests in a basket of investments, that match your attitude to risk, and are monitored regularly.

There’s also ii’s Managed Pension to consider, which enables you to outsource the decision-making to the experts. This could be ideal for you if you want minimum maintenance or lack confidence in choosing investments.

To open a Managed Pension, you answer a few questions about your attitude to risk and investing style and are matched to one of 10 investment portfolios.

But, if you relish research and like the idea of managing your retirement yourself, you can build your own portfolio.

4) Start now and let time do the leg work

The sooner you start saving for retirement, the better.

Time is one of the biggest drivers of investment growth. The later you start saving for retirement, the more of your hard-earned cash you’ll need to save overall.

So, even if you can only afford to save a token amount each month, it’s worth getting started now, instead of waiting until you feel like you can afford to start making more “meaningful” contributions.

Take the example of Sam. She pays £100 a month (including tax relief) into her pension for 30 years. That works out as a total investment of £36,000 in her pension and, assuming returns of 5% a year, it means she ends up with a pot worth £83,226.

Her friend Bob doesn’t think he can afford to save, so he decides to wait until his business is on a firmer footing. He eventually starts his pension 15 years later and tries to make up for lost time by contributing £300 a month. But 15 years later he’s saved a total of £54,000 but his pot is still smaller than Sam’s at just over £80,000.

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Once you’ve started contributing to your pension, it’s important to stay engaged. If you’ve made sensible choices, you shouldn’t need to sweat over your investment strategy, but you need to keep paying money in.

Employed people will see their contributions rise every time they get a pay increase (as contributions are based on a proportion of their earnings). That won’t happen if you’re self-employed, so it’s important to try and increase your contributions from time to time, if you can.

Or, if you’re making lump sum investments, make sure you put reminders in the diary, so they don’t get missed. For lots of self-employed people, completing your tax return – which asks for details of pension contributions – can provide a helpful nudge.

And, again, if your profits are up that year, make sure your pension contribution goes up too.