One of the trickier areas of UK contractor finances is knowing what to do when it comes to your pension. But what’s often overlooked, or simply unknown, is that taking out a pension can save you money through tax relief. Not only that, but contractors are also able to retire at an earlier age of 55.

With employment, a pension is something that’s most commonly taken care of for you. You won’t see the money, but it’s put aside ready for your golden years. However, many contractors often delay taking out a pension plan because they aren’t aware of the benefits or the vast range of options available.

Pensions for contractors in the UK

There is a range of information available on pensions that contractors need to access and keep up to date with. And, with quite a few pension options to choose from, it’s important that contractors fully understand the benefits.

For instance, you can invest up to £40,000 a year without any additional tax implications. This extends to a lifetime allowance of £1m – something that not all contractors are aware of.

There are also plenty of common myths surrounding pensions that simply aren’t true. While many people think otherwise, you can pass on your pension savings on to family members, for example. This is as long as you do so before the age of 75 and haven’t bought annuity.

Also, if you’re not much of a risk-taker, don’t worry. There are options to keep your pension pot in cash, just like opting for an ISA rather than investments in stocks.

This all sounds great, right? Let’s break it down further.

Contractor pensions and taxes

Although pensions and taxes can seem complex at first, it’s pretty simple. Instead of paying tax on your income, you can save most of the tax you would normally pay by choosing to invest in your pension.

For example, you pay 20% of your income in tax – let’s say £20 of £100. If you invested that £100 into your pension then all £100 of it goes into your pension pot for the future. You don’t pay the £20 in tax, or make any national insurance contribution from the sum.

How does tax relief work?

Investing in your pension can be a pretty nifty way of diverting money that you’re paying in tax into a fund for your golden days. But, is it as simple as that? And why aren’t more people doing it?

Although you’re diverting tax money back to yourself, you are also having to take a hit on your current take-home pay. Using the previous example, if you invest that £100 into your pension then yes, the £20 tax will be safe. But you are also having to part with the £80 that you would otherwise have available to spend now.

For contractors who are higher rate taxpayers, you can receive tax relief of up to 40%. This is because of the further 25% tax that they would normally have to pay.

Pensions and IR35

Another huge positive is that the tax-relief remains in place regardless of whether you’re inside or outside IR35.

If you’re outside IR35, you have the option to invest directly from your account or your company bank account. However, the company bank account option is much more tax efficient.

If you’re inside IR35, you’re in luck! You can not only save on income tax (PAYE), but also on both the employers and employees National Insurance Contributions.

Contractors and retirement

If you take action now and start investing in a pension, you’ll be able to access this at age 55. How you use it at that time is completely up to you. You could choose to live off it, or invest it, with many choosing to invest in things that will generate a future income, such as property.

If you choose to rely on a state pension, you should prepare for a large drop in income and consequently a change in your lifestyle. It is a common concern amongst contractors as to whether they’ll qualify for a state pension. But if you’ve been paying national insurance for several years you shouldn’t have anything to be concerned about.

Common misconceptions

Many people delay taking out a pension under the belief that they can ‘catch-up’. But unfortunately, this is not the case. Everyone has a limit to how much they can invest in their pension each year tax-free. Sometimes, allowances can be carried forward. But, if you leave it too long, this may not be the case.

The best thing to do is to start small and start early. You can always increase how much you’re investing as time goes on and you start to earn more. But to begin with, small payments will still have a positive impact in your savings.

A real concern for many is, “what happens to my pension if I die?”

Despite popular belief, families do financially benefit from the contractor’s pension in the UK. If you were to die before retirement age, the whole fund is paid to your beneficiaries, tax-free. If you were to pass away shortly after retirement, there are situations where your beneficiaries can still receive the fund – though this will be subject to tax.

Pension providers

The most important decision when it comes to your pension is choosing your provider.

As a contractor, your employment status can be subject to change at any point, so you need a pension that can, and will, reflect this. This could include increasing or decreasing your investments, pausing them, stopping them completely for some time or restarting them. If this is the case, you’ll need to find a provider that allows you to do this quickly and easily.

You also need to check out the provider’s background. A pension is a long-term investment, so you want to be confident that they’ll be around for the future. All in all, the benefits of taking out a pension plan is unavoidable and worth consideration.

Before you do anything, speak to a financial advisor. They’ll be able to point you in the right direction in terms of providers and advise against any bad deals that are around.

Contractor pensions through umbrella companies

Recognised as an employer, umbrella companies are obliged to offer their employees a range of statutory benefits. This includes a contractor pension, which your umbrella company will pay into as you do.

At Umbrella Broker, we make it refreshingly simple to find the best umbrella company for you. Use our umbrella comparison site to compare leading providers in an instant, with information on the costs, contractor pension and other benefits.