Pensions and being Self Employed

I’ve written before about how pensions can be the best investment that you can ever make. But what happens if you are self employed and you don’t have an employer that is going to match your pension contributions? Is it still worth having a pension?

Short Answer: YES!

Longer answer is that there are lots of different ways for saving for your retirement- and they aren’t all just “save in your pension”, for example you could build a But to Let portfolio, Gold coins, Wine collection- I mean any asset that you can later sell (or get income from) could form part of your pension! In this article I will only be talking about SIPP and LISA for your pension.

SIPP

First of all, I’m assuming you know a SIPP is- its a Self-Invested-Personal-Pension. Basically it’s like a pension that an employer may offer, but with 2 specific differences.

  1. In general only you will put money into the SIPP. Which is perfect if you are self employed since you wouldn’t have anybody else contributing to this anyway.
  2. You are responsible for both the provider you choose to use for your SIPP and everything that you invest in. This is quite different to an employer provided one- since they will have picked the pension provider and there will also be a default fund that most people leave their investments in. This isn’t as scary as it sounds though- as there are lots of funds now that make this as easy as possible to pick from.

LISA

It stands for Lifetime Individual Savings Account. It can only be used for first house purchase, or retirement. If you are over 40 and haven’t opened one, I’m afraid you are unlucky and this option is not possible for you. If you are reaching 40- get one open now, and you can contribute until you are 50. You can only contribute £4,000 a year, and you get a 25% bonus, up to £1,000 per year.

I’ve written an article comparing the two before here if you want more details.

Which is the best for the self employed?

It all depends on your circumstances- but basically if you are a basic rate tax payer then you will probably want to use the LISA, and if you are higher rate- you will want to use a SIPP. Let’s work through an example now, so we can show with figures why one is is better than the other:

EarningsBasic Tax paidHigher tax paidTax rate before pensionTax rate after pension
£40,000£5,484.20£013.7%11.2% (LISA)
£60,000£7,540.00£3,888.4019%12.56%1 (SIPP)
Table showing £40k/£60k earnigs

Basic rate taxpayer

As above, if you earn £40,000 a year then you will be paying basic rate tax of £5,484.20. Opening a LISA is likely the best option for you. With input of £4,000 per year, you will get a bonus of £1,000 on top. When you get to age 60, you can then withdraw your LISA entirely tax free. This would reduce your tax rate from 13.7% to 11.2% assuming that you put £4,000 a year into your LISA.

Higher Rate taxpayer

As in above table, if you earn £60,000 a year, then £8,000 of this will be taxed at the higher rate of 40%- meaning you will be paying at total tax of £11,428.40, of which £3,888.40 is just the higher rate. Now, if you put this whole amount into your SIPP, then you will avoid this higher rate band entirely! This would reduce your tax rate from 19% all the way down to 12.56%!.

Now- there is a caveat with using a SIPP- as there will be some tax due when you withdraw this, unlike a LISA which is entirely tax free. But, even with this condition- a SIPP for a higher rate taxpayer still makes a huge amount of sense because it reduces the tax you would pay now (40%) to tax you would pay later- usually 20% or below.

Pension pot example.

You have managed to save up £500,000 in your pension pot, and you have finished working (so no other income), and at age 57(ish depending on future rules), you want to start getting this money out.

25% pension pot is entirely tax free as a lump, so you can take £125,000 out with no tax at all.

Tax free allowance: £12,579.00

Then 20% tax band from £12.5k to £50k, so assuming you make full use of this, take another £37.5k paying just £7,500 income tax. On the overall amount of £50k withdrawn, your actual tax rate is just 15% (rather than the 40% higher tax rate).

Let’s assume there is no growth of your £500k pension pot, and you take £37.5k per year until it’s empty, after taking that tax free lump sum above. Each year you would pay £4,984.20 in tax, so after 10 years paying £49,820 tax. A tax rate of well under 10%! This is a massive saving over the 40% that would be due if you took the income now.

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