Pension Planning

The value of pensions and the income they produce can fall as well as rise. You may get back less than you invested.

Tax treatment varies according to individual circumstances and is subject to change.

Pensions are currently one of the most tax efficient ways of investing and can be particularly attractive for contractors as they provide opportunities to reduce Corporation Tax charges, in addition to saving towards their future.

The notion of a pension have been around in one form or another for centuries. Gordon Dryden Gilling-Smith’s 1967 Guide to Pensions and Superannuation states that the first recorded pensioner was a gentleman named Martin Horsham, who retired in 1684 on annual income of £40 per year; a considerable sum back then.

Over time pensions have evolved and at various points a vast array of features and benefits have been introduced, some of which are still popular today and others of which have been abandoned. All of these modifications and legislative changes have made the subject of pensions very complex, however the overriding objective of them, which is to provide an income in retirement, remains the same.

What is a pension?

For those unfamiliar with pensions, they are tax efficient savings accounts specifically designed to provide an income in retirement. Contractors have the option of either making contributions on a personal basis, or via their Ltd Company (as employer contributions).

There are a range of different pension products available, each with varying features, options and charges to suit individual needs. Contributions can be made on either a regular or ad-hoc basis.

Pension and tax

Contributing towards a pension is one of the most tax-efficient planning tools currently available.

Any contributions made from personal income (any income specifically subject to income tax) into a UK registered pension scheme will attract tax relief at the individual’s marginal rate. There is also a possibility that additional tax savings can be made by making pension contributions via a Salary Sacrifice arrangement through an employer, which works by deducting pension contributions before calculating the tax liability on the remaining income and reduces the level of income subject to income tax.

As a contractor you have the option to make pension contributions from either personal income or from your business. In our experience, as the majority of income is mostly taken as dividends, which are not classed as taxable income for pension contribution purposes, most contractors opt to make contributions from their company accounts. These are classed as ‘employer’ contributions and are eligible to be claimed as a business expense, which results in a reduction in company profits which are subject to Corporation Tax.

There are limits to the amount of contributions that an individual can put into their pension in a tax year and remain eligible to receive favourable tax treatment. For those with taxable earnings of less than the maximum annual allowance, the maximum contribution will be 100% of relevant UK earnings or £3,600 gross for those with no relevant UK earnings. Company or ‘employer’ contributions are not subject to the limits relating to earnings and can be made up to the annual maximum figure, regardless of the ‘employees’ salary.

Funds held within a pension build up free of taxes until the point that they are withdrawn.

Pensions and retirement

When the time comes for you to start enjoying the fruits of decades of saving for your pension, there will be several questions that you would need to ask yourself, such as:

• Would you like to take a tax free cash lump sum?
• Will you need a secure or flexible income stream?
• Will you need to make provisions for loved ones in the event that you should pass away?

The answers to the questions above are different for everybody and you will no doubt have a very difficult decision to make to ensure the right plan is chosen to suit your needs, especially as it could potentially impact on you for the rest of your life. However, this is something that we can help you with.

Your Options

There are many things to consider when reaching a decision about which option is right for you, such as how much income you will require, your tax situation, your health, willingness to take risk and ensuring the security of your family’s financial future.

The most popular of these options are:

• An Annuity
• An Uncrystallised Funds Pension Lump Sum
• A Flexi-Access Drawdown
• Pension Commencement Lump Sum

We have provided a brief overview of each of these options to demonstrate how your pension funds could be used to provide an income in the future:

Annuity

An annuity is an income for life. An annuity is made possible by exchanging the funds that have been accumulated within pension savings in return for an income, which is usually paid on a monthly basis and guaranteed to last at least until death.

It is arranged via an annuity provider or insurance company on the terms selected by the annuitant (pensioner) and the income is treated as earned income for tax purposes.

The level of annuity payments offered depends on a number of factors, including:

• The value of pension savings to be swapped for a guaranteed income, i.e., the higher the pension fund value to convert, the higher  the annuity income will be.
• The annuity rates within the market at the time of conversion, which are generally affected by interest rates.
• The age of the proposed annuitant. If for example two individuals were applying for an annuity at the same time and had identical pension savings pots but one was younger than the other, the younger applicant would be offered a lower income figure, based on the assumption that they will live longer.
• The options chosen – Such as the option for income to continue to be received by a spouse for a certain period, following the annuitant’s death, or for the payments to increase over time, which results in a lower income in the early years.

+ Pros
• The security of a fixed income for life.
• The option to provide an income for a spouse following death.
• No investment risk is involved.

– Cons
• There is no flexibility in the terms and income levels once the arrangement is in place and no option to take advantage if annuity rates increase.
• The effects of inflation can reduce the income in real terms over time.
• If the annuitant dies soon after taking out the annuity, they will not necessarily have received enough income to cover the value of the pension savings they have given up.

What is an Uncrystallised Funds Pension Lump Sum?

This option provides a facility to withdraw funds from a pension savings pot in a flexible manner as and when required, whilst leaving the remaining funds invested.

It is generally intended for those individuals who:

• Are prepared to continue to accept investment risk to their savings, even though they are using them as a source of income.
• Do not necessarily rely on the income from this arrangement, as they have ample alternative income sources from elsewhere.

+ Pros
• The pensioner retains full control and flexibility over the funds.
• The option to manage income on a tax efficient manner.
• The ability to pass on any remaining fund value to loved ones following death; possibly on a tax free basis.
• The possibility of further growth in fund value in line with investment performance.
• If you later change your mind and wish to purchase an annuity, the rates available may have increased in the meantime.

– Cons
• The risk that fund value will fall in line with investment performance.
• The risk that funds could be exhausted before death, leading to poverty.
• If you later change your mind and wish to purchase an annuity, the rates available may have reduced in the meantime.

What is Flexi-Access Drawdown?

The concept of Flexi-Access drawdown pre dates that of the Uncrystallised Funds Pension Lump Sum option and is very similar, but income is arranged in a more structured manner.

The pros and cons of this option are broadly the same, however, this option is generally available under a specific arrangement which has higher associated administration costs.

This has largely been replaced by the Uncrystallised Funds Pension Lump Sum option, but is still available.

What is a Pension Commencement Lump Sum (PCLS)?

One of the benefits of accumulating a pension fund is the option of taking a Pension Commencement Lump Sum (PCLS) when you retire. This feature is available with most pensions and the amount that can be taken is generally fixed at a maximum of 25% of the fund, but the rules can be different for older style pension plans, where a higher figure could be available.

+Pros
• The pensioner receives a tax free lump sum to spend at their leisure.

– Cons
• Taking PCLS will reduce the amount of funds available to provide a regular income.
• Holding onto this may result in a reduction to state benefits due to a perceived higher level of personal wealth or income.