Contractors remain unclear about how they can best benefit from the wide reaching pensions reforms introduced on 6 April 2015. This lack of knowledge could potentially impact negatively on the retirement plans of many contractors.
“Most contractors are aware that sweeping new pensions reforms were introduced in April 2015, following the Chancellor George Osborne’s announcements in the 2014 Autumn Statement,” explains Contractor Wealth’s pensions and investments expert Angela James.
“Although many understand that they have much greater pensions flexibility at age 55 and on retirement, few are aware of the small print in the changes that could leave contractors without enough savings to support their lifestyle when they stop work.”
What pension reforms were introduced in April 2015?
According to James, the vast majority of contractors know they can take money out of their pension at 55 but few fully understand the implications: “I frequently get asked ‘Can I take money out of my pension?’, but rarely do contractors understand how taking this income will be taxed, their death benefits and the possible impact taking money at 55 will have on their retirement income.”
James summarises the key changes that came into force in April 2015:
- There is no cap on the level of income you can take from your pension pot. Contractors can access as much of their defined contribution scheme pension as they want, subject to income tax, from age 55 and can still also draw down 25% of their pension pot as a tax free lump sum
- The 55% tax on pension assets after death has been abolished. If a contractor died after age 75, the lump sum due to their beneficiaries was taxed at 55%. This has reduced to 45% in the 2015/16 tax year and will be taxed at their beneficiaries’ marginal rate from 2016/17 onwards. Any income due from a contractor’s pension after death will also be taxed at the beneficiaries’ marginal rate.
James warns that less well known are some of the restrictions introduced:
- Once a contractor ‘crystallises’ their pensions benefits at 55 or later, ie they take a 25% tax free lump sum or a greater amount, they can still pay into their pension pot but the annual tax free allowance falls from £40,000 to £10,000
- Apart from the 25% tax free lump sum, any additional funds taken as cash at age 55 will be subject to income tax at the contractor’s marginal rate
- In line with the increase in retirement age 67 due to come into force in 2028, the age at which contractors will be able to access their pension funds will increase from 55 to 57.
How contractors can benefit from pensions reforms
“Savvy contractors understand that the reforms are incredibly useful for more effective retirement planning, but could be dangerous as well,” continues James.
“Limited company contractors commonly have more disposable funds in their business than they need. With the tax relief available from the government, investing in a company pension is an ideal way of utilising that spare cash.”
With the pensions reforms, at age 55 a contractor’s pension fund represents a source of capital wealth that can be used in a variety of ways: “Contractors can clear mortgages on their main home and any existing investment properties, buy a holiday home or an investment property that will generate an income, support their children and grandchildren, or whatever they choose.”
Pension reforms traps for unwary contractors
However, with the new found flexibility comes a fresh range of financial traps for unwary contractors. James explains: “Contractors typically earn a lot of money and have a lifestyle to suit that income.
“But there are still many contractors at age 55 who have not made sufficient provision for a pension that can support that lifestyle during retirement. If they then draw down lump sums from their pension savings at 55, they are further reducing the savings they need to provide an income when they do retire.
“Furthermore, after crystallising their pension contractors can only save £10,000 tax free into their pension pot each year, down from £40,000. This is likely to be nowhere near what a contractor will need to fund a comfortable retirement.”
Contractors warned over cashing in defined benefits (DB) pensions schemes
James highlights that there are further traps for contractors with legacy pensions from previous employments that they may wish to transfer across to their current scheme to access
She explains: “There are two main types of pension: defined contribution (DC) schemes and defined benefits (DB) schemes. The way that a DC scheme works, which is the type of company pension that most contractors will have, is that the contractor’s limited company pays into the scheme, benefitting from tax relief.
“The value of the pensions savings will grow according to how well the pension fund performs, and also the level of fees the contractor pays to the fund manager.”
James adds that DB schemes work differently, and are what many large companies used to offer, and what the state currently offers to their employees: “The employee usually makes a contribution, although not always. On retirement, the employee receives a pension that is based on a percentage of their final salary, either at retirement or in the case of contractors who have legacy pensions like this, when they left the scheme. These schemes are also known as ‘final salary’ schemes.”
DB/final salary pensions schemes transfer restrictions
DB schemes can only be transferred under certain conditions. Pension scheme providers asked to transfer the value of a DB scheme into a contractor’s DC scheme will require proof that the contractor has taken professional financial advice from a registered adviser.
Unfunded public sector pensions for certain roles, such as fire service, police service and armed forces pensions, cannot be transferred.
“Contractors will likely pay in the region of thousands of pounds for that advice and the adviser will only recommend that the DC fund is transferred if it is in the interests of the contractor,” notes James. “And no matter what assets a contractor has, they will still need a stable income during retirement. If they can obtain a percentage of that stable income from a final salary scheme, then why should they transfer it?”
James’ concluding advice to contractors is: “No matter how old you are, it is never too late to start saving and benefitting from tax reliefs and the resulting accelerated growth over time of your pension pot.
“However, there are many pitfalls for the unwary, and I would urge contractors to seek professional advice from a registered adviser before making any significant decisions about their existing and future pensions savings.”