Pension planning for the self-employed

A pension gives you a retirement income, paid for by investments built up during your working life. The state pension is funded by your National Insurance contributions but only provides a basic income. You may need another pension in order to retire comfortably.

If you are self-employed, you will not qualify for the additional state pension (also known as the state second pension). However, you can take out a private pension such as a personal pension or a stakeholder pension. The amount you get at retirement depends upon how much money has been paid in, how well it has been invested and the age at which you retire.

It is important that you consider all your options before making a decision. This guide helps explain how pensions work and what you need to do to find one that suits your needs.

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Assessing your pension needs

Before you choose a pension scheme, try to work out how much money you’ll need each year in your retirement. For most people, retirement comes at a time when they no longer have major outgoings such as a mortgage and therefore need less money to live on. However, as you get older, you need to consider the possibility that you will be faced with other expenses, such as paying for help around the home.

Determining how much pension you will need

In order to have some idea of how much pension you’ll need when you retire, you need to consider the following:

• The age at which you intend to retire. In general, because pensions are payable for life, the earlier that someone retires, the lower their pension. It is important to have a good idea of when you would like to retire as this will determine how much you need to pay into your pension on a regular basis.
• How much basic state pension you will get. 
• What your basic living expenses will be.
• Whether you are likely to have any dependent children.
• The lifestyle that you would like to have in retirement – eg where you want to live, whether you want to travel and what hobbies you have.
• Other assets you may have such as savings, investments and property.

If you already have a pension, how much income will it give you at retirement?

You can ask your pension provider for a statement showing how much your existing pension is likely to pay at the age you intend to retire. This will help you decide whether or not you need to increase your pension payments in order to meet your expectations for retirement.

However, it’s hard to arrive at a reliable figure because the cost of living is likely to have changed by the time you retire. That is why it is important to review your pension arrangements regularly.

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How a personal pension works

With a personal pension scheme, you make regular payments into a fund, which is invested on your behalf.

Basic-rate tax relief on contributions to personal pension schemes

Your contributions will almost certainly attract tax relief. Your pension provider can claim this relief back from HM Revenue & Customs (HMRC) at 20 per cent – the basic rate of income tax.

This means that for every £100 you contribute, £125 is actually added to your pension fund. This is because when you give £100 to the pension provider, this figure represents 80 per cent of the total you earned, before tax. So, the pension provider works out what 100 per cent would have been (£100/80 x 100 = £125) and claims the £25 back for you.

If you pay tax at 40 per cent or 50 per cent you can claim the difference between your tax rate and the basic rate of 20 per cent via your Self Assessment return.  You can get tax relief at 50 per cent up to the amount of your income that is taxable at 50 per cent, and relief at 40 per cent up to the amount of your income that is taxable at 40 per cent.

HMRC will only give customers tax relief on contributions they make to their personal pension in the tax year in which they are paid – they cannot carry back contributions to an earlier tax year.

Level of earnings and tax relief

The amount of pension contributions that qualify for tax relief depends on your earnings during any particular tax year. If you have earnings of less than £3,600 in any year, you can pay in up to £2,880 in a tax year. When basic-rate tax relief is added, this becomes £3,600 – the maximum you can pay in and receive tax relief on if you are not working or have earnings below £3,600.

If you earn £3,600 or more in any year, you can contribute an amount equal to 100 per cent of your earnings and still get income tax relief, as long as the amount is not more than the annual allowance, which is set every year by HMRC. The annual allowance is £50,000 for 2012-13. You can pay in more but you won’t get tax relief on the excess amount.

Read about the annual allowance on the HMRC website- Opens in a new window.

Lump-sum pension contributions

Some schemes enable you to invest lump sums. You may find this particularly useful if you have irregular earnings.

Choosing a personal pension scheme

When choosing a personal pension plan, it’s a good idea to shop around and to consider:

• your current personal circumstances and plans for the future
• the reputation of the pension provider
• past results – but take care, past performance is no guarantee of future success
• penalties and charges that may be made if, for example, you fall ill or take a career break
• how you pay into it – whether you have to pay a regular sum for a given number of years or if you are able to change this, and whether you will be charged for doing so
• whether you can control how your money is invested – for example some companies offer ethical or ‘green’ schemes

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When to cash in your personal pension

You can draw upon your pension fund from the age of 55.

Lump-sums, annuities and drawdown pensions

You can currently take up to 25 per cent of the fund as a tax-free lump sum – if it is less than 25 per cent of the ‘lifetime allowance’ for that tax year. This must also be within your pension scheme rules and your total savings must be within the ‘lifetime allowance’ for the year in which it is taken. The remainder must be used to either purchase an annuity – a form of investment that pays you an income for the rest of your life (a pension) – or to draw payments directly from the scheme as a ‘drawdown pension’.

When you die, the annuity stops unless it is guaranteed to be paid for up to ten years. If you die before taking benefits, a life insurance element provides for your dependants. However, when you buy your annuity you can make provision for all or part of it to pay a pension to your spouse or partner, should you die before them.

Taxation of pension payments

All payments that you receive from your pension fund (apart from the tax-free lump sum) are subject to income tax if these payments, plus any other sources of income, take you over the annual income tax threshold. In addition, your pension fund has a ‘lifetime allowance’ limit, which is set by the government. This limit is £1.5 million for 2012-13.

Read about the annual allowance on the HMRC website- Opens in a new window.

The value of savings above this limit will be subject to a charge, as follows:

• if you take benefits as a pension, the charge on the pension above the lifetime allowance will be 25 per cent, in addition to income tax
• if you take benefits as a lump sum, you will pay 55 per cent on the excess over the lifetime allowance, in addition to income tax

The charge will be made either when you start to take your benefits, or when you are 75 if you delay taking an income.

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The basic state pension

If you have built up enough qualifying years before state pension age, you can get a basic state pension.

What is a qualifying year?

A qualifying year for a basic pension is based on the National Insurance contributions you have paid, have been treated as having paid or have been credited with during a tax year. The tax year runs for the 12 months between 6 April and 5 April of the next year.

The number of qualifying years you will need

The number of qualifying years needed for a basic state pension depends on your gender, your state pension age (SPA) and the date when you reach SPA. You need:

• 44 qualifying years if you are a man with an SPA of 65 and reach this age before 6 April 2010
• 39 qualifying years if you are a woman with an SPA of 60 and reach this age before 6 April 2010
• 30 qualifying years if you reach SPA on or after 6 April 2010

If you do not have sufficient qualifying years, your basic state pension may be reduced. The full basic state pension for 2011-12 is £102.15 per week.

How much state pension may I get when I reach SPA?

There are two ways that you can find out how much state pension you may get. You can use the online state pension profiler on the Directgov website. Using information that you provide, this can help you estimate the amount of the basic State Pension you may get and when you can claim it. It will also help you see how you are affected by changes to the state pension. You can access the State Pension Profiler on the Directgov website- Opens in a new window.

You can also get an estimate of the State Pension you may get, including any additional State Pension and Graduated Retirement Benefit, based on your National Insurance contributions record. You can find more information on how to get an estimate of your State Pension on the Directgov website- Opens in a new window. Alternatively, you can call the Future Pension Centre Enquiry Line on Tel 0845 3000 168 and request one.

What is the SPA?

SPA is the earliest age from which you can get your State Pension. The SPA is increasing. For men it is 65. For women, SPA has been increasing from 60 since April 2010 and will be the same as men’s by November 2018.

From December 2018, SPA for men and women will increase so that it will be 66 by October 2020.

The current law already provides for SPA to increase further to 67 and 68 in the future. However, the government has announced that it is considering revising the timetable for these future increases.

Pension credit

If you have reached the Pension credit qualifying age you may be entitled to pension credit. Pension Credit is made up of two parts Guarantee Credit and Savings Credit. The Guarantee Credit tops up your income to a guaranteed minimum amount if you have reached the qualifying age. The Savings Credit is for those who have saved some money towards their retirement such as in a pension, you may be able to get it if you are 65 or over.

The age from which you may get Pension Credit – the qualifying age – is gradually going up to 66 in line with the increase in the State Pension age for women to 65 and the further increase to 66 for men and women.

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Stakeholder pensions

Stakeholder pensions are flexible and portable and must meet strict government standards. They are available to the self-employed, contract workers, employees and the unemployed. It may be worth considering a stakeholder pension if you:

• are a moderate earner
• have an irregular income or low earnings but can afford to save
• wish to top up other pensions

An independent financial adviser can help you identify the best pension product for you.

Find out about stakeholder pensions on the Pensions Advisory Service (PAS) website- Opens in a new window.

How do they work?

Stakeholder pensions operate in much the same way as personal pensions but must satisfy minimum standards:

• Capped charges – stakeholder pension providers cannot charge more than 1.5 per cent of the value of your pension fund a year to manage it for the first ten years, falling to 1 per cent thereafter. However, pension providers are allowed to make certain charges outside the charge cap – eg they will pass on stamp duty for buying and selling investments on your behalf.
• Extras are optional – any extra services and charges not provided for by law must be optional. These include advice on choosing a pension or life insurance cover. You must have agreed to these extra charges as a separate arrangement and the charges for the services must be clearly defined.
• Low minimum payments – schemes will accept contributions of as little as £20 or even less. 
• Flexible contributions – you choose when and how often you pay into the scheme. If you stop paying your contributions for a time the stakeholder pension provider will not charge you extra.
• Penalty-free transfers – if you choose to transfer into or out of a stakeholder pension there will be no extra charges. 

Read about stakeholder pensions on the Directgov website- Opens in a new window.

How to choose a stakeholder pension

When selecting a stakeholder pension, you should ask the provider:

• What are the charges?
• Will advice or other services be provided within the charge cap?
• Where will your contributions be invested and what input will you have?
• Is there a cooling-off period in case you change your mind?

Compare pension schemes using the comparative tables on the moneymadeclear website- Opens in a new window. You can also search the register of stakeholder pension schemes on the Pensions Regulator website.

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Other pension products

There are a number of other private pension products which you could consider instead of – or in addition to – stakeholder pensions.

Insured personal pensions

An insured personal pension is one where a fund manager makes investment decisions on your behalf. The investments should be unique to your particular fund and specific to your needs. A life insurance company manages the assets and the fund manager must be authorised by the Financial Services Authority (FSA). This type of pension includes privately managed funds.

Self-invested personal pensions (SIPPs)

SIPPs enable you to select pension fund investments yourself.

The investments may be of a single type or a combination. Types of investment commonly chosen for SIPPs include:

• hedge funds
• commercial property
• real estate investment trusts – these are organisations that invest members’ funds in property
• unit trusts – where you buy units in the mix of investments an investment company holds
• equities – where you buy shares in quoted companies, usually through a stockbroker
• government securities – eg up to the tax-free limit on a national savings account
• cash, usually in the form of long-term, high-interest accounts

With SIPPs, you get tax relief on the money you pay in, you don’t pay capital gains tax on any growth in your investment and you may get a tax-free lump sum when you start drawing your pension.

You do not have to buy an annuity at any point from an insurance company but can simply draw an income from the pension fund if the scheme rules for this.

Life annuities and capital protection

One way of investing the tax-free lump sum received on retirement through a pension scheme is to buy a purchased life annuity. The regular annuity payments received are split into ‘capital’ – representing repayment of the purchase price, which is tax free – and ‘income’ elements.

The income element is automatically taxed at 20 per cent. However, if you are a low earner, you can reclaim this tax from HM Revenue & Customs (HMRC) and register to stop paying tax on the income in future.

Read about reclaiming tax paid on purchased life annuity income on the HMRC website- Opens in a new window.

You can also take out a kind of insurance against your early death called capital protection, which is another type of annuity product. It ensures that if you suffer an early death, the difference between the gross income that is received and the original capital to buy the annuity is paid as a lump sum into your estate.

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Other tax-efficient savings – ISAs

An individual savings account (ISA) gives you an alternative – or additional – way of saving for your future. However, saving into a pension is normally the best way to save for retirement as this gives you an income for life. Relying on ISAs without the back-up of a pension can be risky.

What is an ISA?

An ISA is a tax-free investment allowance, covering investments such as stocks, shares or unit trusts. You don’t pay tax on income from them or on capital gains if they increase in value.

There are two types of ISA: stocks and shares ISAs and cash ISAs. You can invest in one of each type in each tax year. The amount you can invest is subject to the following limits:

• No more than £11,280 per year in total in a stocks and shares ISA with one provider.
• No more than £5,640 per year in a cash ISA with one provider. The remainder of your £11,280 can then be invested in a stocks and shares ISA – eg if you invest £2,000 in a cash ISA in a tax year, you can invest up to £9,280 in a stocks and shares ISA with either the same or another provider.

To find the best ISA for you, access the comparative tables on the Money Advice Service website- Opens in a new window.

The pros and cons of ISAs

The advantages of an ISA are that you get more control over your savings and that they are easy to track and understand. ISAs are flexible and unrestrictive in that you can change to another provider and access and invest into the fund at any time. You also do not have to pay income tax on any growth in the value of an ISA.

The disadvantages are that you will miss out on tax relief on initial contributions, plus they may not be a particularly reliable investment for long-term saving as they could be withdrawn in the future.

Find out more about ISAs on the HM Revenue and Customs (HMRC) website.

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Transferring your pension

You may be thinking about transferring your pension, perhaps because you have seen another pension product offering more attractive benefits.

Before you do so, take a close look at the penalties of leaving your existing scheme. Ask your pension provider for a transfer value to find out how much you stand to lose. You may decide that, even with the penalties incurred, it is still worth transferring to the new scheme. Make sure you have compared the different products as closely as possible, particularly projections of final income.

Note that there is no cooling off period if you transfer a pension, so it’s vital to get it right. There is no charge for transferring a stakeholder pension.

Starting an additional pension scheme

If you decide that it’s not worth transferring your pension you may instead be able to start up a new pension scheme in addition to your existing one.

However, check whether or not you can reduce payments to your existing pension and whether there is a charge for doing this. If you can reduce payments to your existing scheme, you will be able to pay more into the new scheme instead.

The consequences of transferring your pension are significant, so you might like to get professional advice. The Pensions Advisory Service Helpline on Tel 0845 601 2923 can give you information and guidance.

Find out how to complain or resolve a dispute with a financial organisation on the Financial Ombudsman Service website- Opens in a new window.

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Keeping track of your pension

Don’t forget about your pension. As your earnings change you may want to adjust contributions, and the nearer you get to retirement the more you can pay in.

Take stock

When you get your annual pension statement take some time in assessing your pension needs to see if your pension is still suitable. The statement will include an illustration of your pension income in today’s prices.

Get forecasts

Some pension providers and employers are already offering combined pension forecasts, which give you an estimate of what you can expect to receive from your company scheme and the state, including the basic state pension. See the page in this guide on the basic state pension.

If it looks like the fund won’t meet your needs, you could increase your contributions or consider an additional scheme.

If you have lost track of a pension

If you think you have entitlement to a pension but for some reason are no longer in contact with the company and have lost touch with the pension scheme, the Pension Tracing Service may be able to help – trace an old pension on the Directgov website- Opens in a new window or call The Pension Tracing Service Enquiry Line on Tel 0845 600 2537.

Problems with your pension

If you have a problem with your pension that can’t be sorted out by the provider, you can get help with pension problems on the Pensions Advisory Service (PAS) website- Opens in a new window.

If you have a complaint about the way you have been sold a pension, you can contact the Financial Ombudsman Service. Find out how to complain or resolve a dispute with a financial organisation on the Financial Ombudsman website- Opens in a new window.

If your complaint relates to managing the fund once you have bought it, you can find out how to make a complaint on the Pensions Ombudsman website- Opens in a new window.

You can also take professional advice from an Independent Financial Adviser or contact the Pensions Advisory Service Helpline on Tel 0845 601 2923.

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