If you’re looking for a good conversation killer this Christmas, try bringing up pensions. We all know they’re basically a good idea, but being bombarded with the message that you’re not saving enough can be a little demoralising. The main message though is that pensions are the best way to save enough money to stop working one day. The more you save, the earlier in life you can stop working.
Unfortunately as a freelancer you don’t have a pension set up for you, so it’s on you to take the first step. But they can be confusing and hard to navigate. So we wanted to change the conversation a little and explain the four things freelancers really need to know about pensions, so you can start saving and stop working.
When you pay into a pension the government reimburses you for any income tax you have paid on that money. That means if you’re a freelance sole trader, for every £100 you save into a pension the government will add £25 directly into your pension. Every £1,000 they add £250… right up to £60k per year (or your total annual earnings if that’s lower).
If you’re earning more than £50k a year, the government will add a massive £667 to every £1,000 you pay. The first £250 will be paid direct into your pension, but the rest you need to claim on your self-assessment tax bill. Our partners TaxScouts have a pension tax relief calculator that'll calculate how much tax relief you could claim.
There’s no other way to save that gives you such a boost (the Lifetime ISA gives some comparable benefits for basic rate tax payers but with much lower limits). The obvious catch is that you can’t take out the money until you’re 55, but then you can take the first 25% of your whole pot with no tax either.
If you operate a limited company, it’s a little different, but actually even better! Read on to find out more…
If you operate as a limited company, you can pay from your business into your pension and offset the cost against your corporate tax bill. For company profits up to £50,000, every £1,000 you pay into your pension reduces your corporation tax bill by £190 (or 19%). In other words it has only cost you £810 for every £1,000 you pay into your pension. That’s a 23% boost!
The amount you can reduce your corporation tax bill by can be up to 25%, but it depends how much you have paid into your pension and how much the company profits are. You can find more information here.
If you have enough money from your salary & dividends for your living expenses and short/medium term savings needs, it’s one of the best ways to extract further value from your business.
If instead you took the additional money as salary you would pay additional national insurance and income tax, and if you took it as dividend you would pay dividend tax. Transferring it to your pension means you don’t pay any tax on it all, plus you get the reduction to your corporation tax bill.
The government doesn’t top up the £1,000 any further, like they do for sole traders, but sole traders will have already paid income tax on that money, which is just getting reimbursed by the government when they top it up. So you are almost always better off paying in from your company.
The state pension is currently £10,600 and if you were born after 1971 will only available when you turn 68 (it may be available a year or two before that if you were born earlier). Although the government promises to increase it with inflation each year, that is still unlikely to be enough to live off comfortably, which is why building up a private pension is so important.
However some self-employed people might not even be able to benefit from it at all. To receive the full amount you need to have been paying national insurance for 30 years. If you’ve been paying national insurance for between 10 and 30 years you will get some proportion of the full amount.
Many self-employed people with their own limited companies will restrict their salary to the minimum level so that they don’t pay national insurance, and take the rest in dividends. If you are a long-term freelancer it is worth considering increasing your salary a little to start paying national insurance so you can benefit from the state pension.
The money you save in your pension is invested in stocks and bonds to generate investment returns. Over the long term, you might expect it to grow by an average of around 5% to 7% per year.
This might not sound huge but thanks to the magic of compound interest, which Einstein called the most powerful force in the universe, this repeated annual growth generates a snowball effect over the long term. A rate of 7% would mean your money roughly doubles every 10 years.
That means if you invested £1,000 at age 20, it might grow to about £15,000 by age 60. However if you waited 10 more years and invested it at age 30, it might grow to only £7,600.
Or perhaps one that’s a little more scary: if you saved £100 a month for ten years from age 20 to 30, assuming that 7% growth rate plus the 25% government top-ups, you would have the same amount at age 70 (about £320k) as if you had saved £100 a year for forty years from age 30 to 70!
Starting at 20 and stopping at 30 would only cost you £12k to get that £320k, whereas starting at 30 it would cost you £48k - four times as much!
This is why it is so important to start as soon as you can, as the biggest weapon you have in terms of saving enough money to stop working, is time!
Tax benefits do depend on your individual circumstances and might change in the future. With pensions, as with all investments, your capital is at risk and the value of your pension may go up as well as down. You may get back less than you put in.
Penfold Co-CEO and Co-Founder