PENSION PLANNING FOR THE SELF-EMPLOYED THE RECENT TAYLOR REVIEW DELIVERED A SET OF STARK STATISTICS ABOUT HOW FEW SELF-EMPLOYED PEOPLE ARE SAVING FOR THEIR RETIREMENT As there are more than 4.8 million self-employed people in the UK, according to the Office for National Statistics, it s clear that a large proportion of the working population are not saving for retirement. Whilst these are worrying figures, this does potentially present a good opportunity for advisers. Advisers who have focused mainly on employee pension provision, or who don t regularly deal with self-employed clients, may find that it can be more complicated to work out the correct level of relevant UK earnings for self-employed people compared to clients who are operating through limited companies. However, the benefits could make it worthwhile. This makes for a good time to revisit how pension planning works for the self-employed. PENSION TAX RELIEF FOR THE SELF-EMPLOYED Self-employed individuals can contribute to a personal pension, or if they already have one, a retirement annuity contract. If they contribute to a personal pension, they will be treated as paying in a net amount and the Government will top it up as follows: Adding 1,000 to a personal pension costs 800 with the Government paying in the rest You pay in 800 The Government pays in 200 If the individual is a higher rate taxpayer they can reclaim a further 200 of tax back from the Government, so that the net cost of their 1,000 contribution is 600. (If they were able to contribute to a Retirement Annuity contract they would pay in 1,000 and get 400 of tax back from the Government; so the same net cost as a personal pension contribution.)
If the individual also wants to reinvest the higher rate tax refund on an 800 net contribution into their pension, one way is to pay in a higher amount to start with. This is worked out as: 800 x 100/60 x 80% so the amount the individual would pay in is 1,067; The Government adds 267 so that total amount added to their pension pot is 1,334; and The individual can reclaim a further 267 in higher rate tax so that the net cost of getting 1,334 into their pension pot is only 800. Increasing a pension contribution to 1,334, only costs a higher rate taxpayer 800 1,067 paid in minus 267 tax refund received later with the Government paying in 267 You pay in 1,067 The Government pays in 267 The Government refunds you another 267 HOW MUCH CAN A SELF-EMPLOYED INDIVIDUAL PAY INTO A PENSION? Like all individuals, the amount a self-employed person can pay into a pension is dictated by their relevant UK earnings, or the 3,600 limit if higher. Relevant UK earnings for a self-employed person is likely to be the tax adjusted profits from their business, unless they have separate sources of relevant earnings, like earnings from employment or furnished holiday lettings. Losses don t need to be deducted to calculate relevant UK earnings, even if those losses have been deducted to reduce the individual s tax bill. However, the impact of those losses on the rate of tax payable by the individual has to be considered as that will affect the rate of tax relief available on their pension contribution. Relevant UK earnings can t include investment income such as dividends and interest, or rental profits that don t qualify as furnished holiday lettings. Furthermore, pension income, such as from the State Pension, an annuity, a Final Salary scheme or a drawdown plan isn t classed as earnings so cannot be included in the definition of relevant UK earnings. Assuming they have no other earnings, a self-employed person s relevant UK earnings will usually be the taxable profits figure for the accounting period that ends in the same tax year as their pension contribution. For example, relevant UK earnings for the tax year ended 5 th April 2018 could be profits for an accounting period ending 31 st December 2017 or 31 st March 2018. Profits are normally calculated over a 12 month period, such as 1 st January to 31 st December, although it s possible to have longer or shorter accounting periods and to change year end dates. The taxable or tax adjusted profit figure is the figure after the profit from the self-employed person s profit and loss account has been adjusted by non-taxable income, disallowable expenses and capital allowances. Usually, this will be shown on a Tax Computation prepared by the self-employed person s accountant. 1
Let s look at an example: Harry started his business on 1 st May 2010 and his tax adjusted profit for his first year of trade was 24,000. His recent tax adjusted profits from his Tax Computations for the years ended 30 th April are: 2015: 30,000 2016: 50,000 2017: 40,000 What is the most that Harry can put into his pension in the tax year ended 5 th April 2018? The answer is 40,000. This is because the accounting period ended 30 th April 2017 ends in the tax year ended 5 th April 2018. Note that even if Harry has unused annual allowances from earlier tax years, he can t pay in more than his 40,000 relevant UK earnings in the tax year ended 5 th April 2018. It can be difficult to work out an exact figure for relevant UK income for self-employed people with year ends that are nearer to the tax year end, like a 31 st March year end. For example: Helen s tax adjusted profits for the years ended 31 st March are: 2015: 30,000 2016: 50,000 2017: 40,000 What is the most she can put into her pension in the tax year ended 5 th April 2018? The answer is that she won t know until after 31 st March 2018. As she only has 5 days after her accounting year end to make her pension contribution, she or her accountant is probably going to have to estimate her tax adjusted profit for the year ended 31 st March 2018, erring on the side of caution so that she doesn t overpay. However, she might be able to pay a last minute top-up to her pension if it becomes clear before 5 th April that her income is higher than the estimate. If she overestimates her relevant UK earnings, it s likely that her provider will refund the non-tax relievable amount as most providers won t accept payments in excess of relevant UK earnings. The provider will also return HMRC s 20% tax addition back to HMRC. By contrast, Harry should have the information he needs about his relevant UK income for the tax year ended 5 th April 2018 in plenty of time to make a decision about his pension contribution as he has eleven months after his 30 th April 2017 year end. Where a self-employed business starts up or closes down, or changes its accounting year end, the way that profits fall into the individual s relevant UK earnings for a tax year can be more complicated. 2
Here are two further examples: 1. Start-up Rachel started her business on 1 st August 2017 and plans to prepare her first set of accounts to 31 st July 2018. She estimates that her profit for her first year will be at least 30,000. As it s her first year of trade, the period from 1 st August 2017 to 5 th April 2018 is taxed in the year ended 5 th April 2018, and the whole year from 1 st August 2017 to 31 st July 2018 is taxed in the year ended 5 th April 2019. Because of how the tax system works for self-employed people in their first year of trade the period from 1 st August 2017 to 5 th April 2018 is taxed twice. The reverse treatment will apply when she closes her business, or if she moves her year end closer to 31 st March. The practical issue for Rachel is that she or her accountant will have to estimate her relevant UK earnings for the tax year ended 5 th April 2018, and she won t know the exact figures until it s far too late to do anything about it. Based on her current estimate her relevant UK earnings for the tax year ended 5 th April 2018 will be 248/365 x 30,000 = 20,383. By contrast, Rachel should have the information she needs about her relevant UK income for the tax year ended 5 th April 2019 in plenty of time to make a decision about her pension contribution for that year as she has eight months after her 31 st July 2018 year end. 2. Cessation of trade Harry ceases to trade his business on 30 th November 2017. His profit for the period from 1 st May 2017 to 30 th November 2017 is 15,000. As he has ceased trading on 30 th November 2017, the profit from the whole period from 1 st May 2016 to 30 th November 2017 is taxed in the year ended 5 th April 2018, i.e. 55,000 ( 40,000 plus 15,000). However, it s necessary to deduct any profit taxed twice when he started up the business in 2010. As he chose a 30 th April year end, eleven months of his first year profit of 24,000 was taxed twice, so, 22,000 is deducted (i.e. 11/12 x 24,000). The accountant has to keep a record of this figure. This means that Harry s relevant UK earnings for the tax year ended 5 th April 2018 is only 33,000. MONTHLY PENSION CONTRIBUTIONS With employees, pension contributions are often linked to monthly salary as a percentage and therefore increase when their salary rises. This is in contrast to the self-employed as their profits fluctuate, a monthly pension contribution won t automatically increase or decrease in line with changes in their income. This can mean that self-employed pension contributions won t keep up with increases in the rate of inflation, so some method of inflationary increase may need to be incorporated such as an annual RPI based increase. Of course, employee pension contribution increases may not keep up with inflation either and may need to be topped up. However, self-employed individuals may also need to alter their monthly pension contribution levels year on year if profits are likely to increase or decrease substantially, and they may also need to react to any unexpected profit fluctuations. 3
OTHER PLANNING CONSIDERATIONS It s important to remember that self-employed pension contributions can also be restricted by the annual allowance, the money purchase annual allowance, the tapered annual allowance and the lifetime allowance, just like employee and employer contributions, so all of these factors need to be taken into consideration when planning. The above examples look at self-employed people with relatively low levels of income in order to demonstrate the principles. However, anyone advising self-employed people with much higher levels of profits may find that they only need to satisfy themselves that their client s relevant UK earnings is above their intended pension contribution and that their total income doesn t exceed the 150,000 Tapered Annual Allowance threshold. Of course, the client s accountant should always be consulted if there s any doubt over the level of their relevant UK earnings often a good opportunity to build professional connection relationships! Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given. Scottish Widows Limited. Registered in England and Wales No. 3196171. Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number 181655. 56304 10/17