Pensions: an explainer for the self-employed

In 2020 the institute for Fiscal Studies (IFS) published some research which showed that the proportion of self-employed people contributing to a private pension had declined to 16%. This has been on the decline over time. In 1998 48% of the self-employed contributed to a private pension, yet today employees are far more likely than self-employed people to contribute to a private pension.

This is a worrying trend – so today on pension awareness day we’re encouraging self-employed people to save into a pension.

What is a pension? 

A pension is just a pot of money. You pay into it as a way of saving for retirement. If you pay tax, you’ll get tax relief on what you put in. You can then choose how to invest your pension pot.

You cannot withdraw money from your pension until you reach a certain age, which is currently 55 (in a few rare circumstances such as terminal illness you can). If anyone approaches you to suggest taking money out of your pension before this age, it is a scam.

Why should self-employed people pay into a pension? 

Tax 

Tax relief is a really important reason to pay into a pension, which applies to both the self-employed and employees. Self-employed people are eligible for a type of tax relief called “relief at source”. This means that when you pay money into your pension, the government will top it up, paying you back the tax that you have paid on those earnings.

If you’re a basic rate taxpayer, you automatically get 20% back from the government when you pay into your pension pot. If you are a higher rate taxpayer you can claim an extra 20%, and if you’re a top-rate taxpayer you can claim an extra 25%.

For example, if you’re a basic rate taxpayer, and you put £80 into your pension, you will get £20 of tax relief from the government.

If you’re self-employed it’s also sometimes possible to offset some of the money you pay into your pension against your tax bill. Seek financial advice about doing this.

Money for retirement 

How much you save for your retirement is a really personal choice and will depend on the type of lifestyle you want to lead. There are some “rules of thumb” that you might find useful.

One rule is that you will probably need between 50% and 70% of the income you have at the end of your career when you retire.

Calculations have been done to work out the minimum income you’ll need in retirement. The PLSA’s retirement living standards calculator estimates suggest that for a single person

• A luxury retirement income would be between £33,000 a year
• A comfortable retirement would be £20,200 a year
• A basic retirement would be between 10,200

Their website provides a useful look at what your standards of living would be like on those incomes. Take a look and see what applies to you. Remember there will be difference depending on factors such as whether you are a renter or a homeowner.

If you get the full state pension, this is currently £179.60 per week. Remember, to get the full state pension you need to make enough national insurance payments.

All of these estimates are just that, estimates. Your lifestyle may mean your own costs are different, and it’s worth thinking about how much you will need to get by in retirement. Most costs decrease for people as they retire, for example, many people have paid off larger costs like mortgages, and don’t have to pay costs associated with commuting and working such as train fares, office-wear or high petrol costs.

Another rule of thumb some people use is to save the percentage of your income that’s around half your age when you start paying into a pension. So, for example, if you started paying into your pension when you were 24, you’d pay 12% of your income into your pension. If you started when you were 30, it would be 15%. The lesson with this rule is that the sooner you get started the better. The compound effect of your investment returns could mean a small investment grows into a lot more. But if you’ve left it a bit later, don’t panic, you just need to save a bit more.

Broadly though, work out how much you need, and you can often find calculators that will tell you how big of a pension “pot” you will need to have saved in order to get this income in retirement.

Other questions about pensions: 

Where should I invest the money that’s in my pension? 

This will depend on your risk appetite. You can choose to invest your money in stocks and shares, bonds, cash, or other financial products. Many people choose to invest in a managed fund, where their pension company buys up a range of stocks and bonds to reflect a given “risk profile” and manages it for you.

The risk you want to take may also depend on your age. Many pension funds automatically start to move you into lower risk options as you approach retirement.  That’s because as you get closer to retirement you have less time for your investments to recover if there was a big crash. But if you’re earlier in your career, it can be better to take more risks, as there is more time for markets to recover, and you’ll get more growth which could compound in the long run, giving you more income in retirement.

If you want advice about your pension investments, it’s best to speak to a financial advisor. Unfortunately, we cannot give you specific advice about your pension investments.

Sometimes pensions get a bad reputation. Usually that’s caused by people being hit with high charges or choosing investments that don’t pay off. But remember, the level of risk comes with the investment choices made and isn’t inherent to a pension itself.

How much can I put into a pension? 

You can put as much in as you like. But be aware that there are some limits on how much tax relief you can get.

First there is an earnings limit. You can only get tax relief on pension contributions up to your annual earnings. So, if you earn £25,000 a year, you can get tax relief on up to £25,000. You could still put in more than £25,000 (if you had other savings, for example), but it might make less sense.

There’s also an annual limit of £40,000. This limit affects high earners. You can get tax relief on £40,000 plus anything left over from your allowance from the previous three tax years. There’s also a limit on tax relief for people earning over £240,000.

Finally, there’s a lifetime limit of £1,078,900. If you’re lucky enough to max out your pension savings, then you could face a tax charge.

What should I do when I retire? 

When you retire you then have choices about what to do with the money you’ve built up. You can leave it in your pension, take some of it out (25% of it can be withdrawn as a tax-free lump sum) or buy products such as annuities (which give a guaranteed income) or a flexible drawdown product (which keeps most of your money invested but allows you to take some income out of it).  These different decisions have different tax consequences.

This is a really important decision so it’s important to think through what you’re doing to do and get advice.

You can get free advice about your pension from pensionwise.gov.uk, over the phone with the pensions advisory service, from Citizen’s advice.

You can also get independent financial advice and it’s often a good idea to do so.

Where can I find out more about pensions? 

Martin Lewis (Money Saving Expert) is a great place to start: https://www.moneysavingexpert.com/savings/discount-pensions/