Pensions for the self-employed

Disclaimer: This post is intended to give you information about the pensions options for the self-employed. It is not advice on whether you should save into a pension, and if so which scheme to use or how much to contribute. If you want to speak to someone about your personal circumstances, call The Pensions Advisory Service (free) or an independent financial advisor (£££). I also haven’t included details of minimum and maximum amounts as these usually change each year.

One of the biggest downsides to self-employment is that there are no automatic schemes (other than the State Pension) which will provide you will an income in retirement — which for the vast majority of people consist of one or more pensions. This means you will have to sort out your own pension provision, or pay someone else to do this for you.

The state pension

The good news is that you’ve probably already built up one pension without realising it. For every year that you pay class 2 national insurance contributions (you pay these automatically if you are registered as self-employed, although it is possible to opt out if your earnings are low) you get credited with a qualifying year. The more qualifying years you have, the more State Pension you get, subject to a maximum.

The State Pension is paid by the Department for Work and Pensions and is guaranteed to be paid for as long as you live, even if you end up spending thirty years or more in retirement. The major downside is that how much you get and when is subject to the whims of current and future governments.

You can check your State Pension online for free and see how many qualifying years you have accrued so far. However, the State Pension on its own is limited to around £160/week, so you may want to supplement it with additional funds to enjoy a comfortable retirement.

How pensions work

With the exception of the State Pension, all pension schemes for the self-employed work along the same lines:

  1. You make cash contributions during the course of your working life, either in monthly installments or a lump sum (or both).
  2. These contributions are invested with a view to growing your fund above inflation.
  3. At retirement, the value of your fund is used to buy a guaranteed income for life (an annuity) or to provide an ongoing income which is not guaranteed (known as drawdown).

Broadly speaking, the more contributions you make, the earlier you make them, and the better the performance of your investments, the bigger the fund you will have and the more income you will receive at retirement.

Pension types

For the self-employed there are three types of pension schemes:

  1. Personal pensions: You pay contributions to the pension provider and they automatically invest them for you. You can choose which fund your contributions go into but the individual investment decisions are taken by the provider.
  2. Self-invested personal pensions: Similar to personal pensions, but you have much more control over where your contributions are invested (e.g. you can invest in specific companies and commercial property).
  3. Stakeholder pensions: These are similar to personal pensions, but come with restrictions on maximum charges and a few other protections. However, the restriction on charges does not mean they are guaranteed to be cheaper than other options. They are also intended to be portable, so if you decided to return to employment you may be able to take your pension with you.

There are no restrictions on how many pensions you can have, although the amount you can contribute across all pensions is subject to annual and lifetime allowances (the lifetime allowance is currently £1m and therefore not an issue for most self-employed people). You may also find it easier and cheaper to manage all of your pension savings in one place, and it is usually possible to transfer between providers.

Tax on pensions

The great thing about pensions is that you get the tax back on any contributions you make, subject to an annual limit. Even better, your pension provider will automatically claim most of this tax relief for you and credit it to your pension fund (if you pay tax at rates above 20%, you have to claim the difference back via self-assessment). The other advantage to pensions is that your fund grows free of income tax and capital gains tax.

However, you will be taxed on any income you take from a pension once you reach retirement, whether you buy an annuity or enter drawdown. You can take a tax-free lump sum up to a maximum percentage of your pension, though this will reduce any income you receive.

Entering retirement

Generally speaking, you can start to receive benefit from your pensions once you reach 10 years below the State Pension Age. The State Pension Age is currently 65, which means that you can’t access your pension until you are at least 55, and this may have gone up (it only goes up, never down!) by the time you reach it. As mentioned earlier, you have two options:

Buy an annuity: An annuity is an insurance product which you buy for a fixed amount and it guarantees to pay you a specific income for the rest of your life, regardless of how long you live. The amount you will get depends on a number of factors such as your health, whether you want your partner to receive an income after you die, whether you want the amount to increase in line with inflation etc. At the moment, you can expect to receive roughly 3-6% per year from the amount you pay, so if you buy an annuity with £100,000 you’ll receive an annual income of £3,000-6,000 for the rest of your life, whether you live for one day or forty years.

Drawdown: With drawdown you leave your pension fund invested and take an income from it whenever you want. Effectively you retain the risk of your fund falling in value, instead of transferring this risk to an annuity provider, but on the other hand you also retain the benefits of any growth. If there is still a fund left when you die, the remainder can be left to other people such as children or charity.

You can also split your pension pot, using part of it to buy one or more annuities and the rest to provide an income via drawdown.

I hope the above is useful for fellow freelancers. If there’s anything else you’d like to know that’s purely factual (i.e. not personal advice), please let me know in the comments.

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