Self-employed? Here’s the best way to save for your retirement

So, at some point you decided to make the leap. You ditched the financial security and routine of your 9-to-5 job and dived headfirst into the exciting but unpredictable world of self-employment.

And being your own boss, whether you freelance or employ others, has obvious appeal. You have the freedom and flexibility to live your working life on your own terms, something that many of us crave, and there’s no cap on what you can earn.

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That said, self-employment isn’t all milk and honey. Not only is it hard graft but there’s lots of uncertainty, too. You also miss out on valuable financial benefits that your employed counterparts enjoy, such as paid holiday and life insurance – and perhaps most notably, a company pension.

Under auto-enrolment rules, you automatically join a company pension scheme shortly after you start a new job. All you need to do is commit 5% of your salary (within certain limits), and your employer must pay in 3%. There is little to no admin on your side, other than choosing where you’d like to invest your savings every month, and even then, there are default investment options.

But as auto enrolment isn’t available to self-employed workers, the responsibility of tucking enough away for retirement rests firmly on your shoulders. Here are some of the key questions you need to ask to help you retire on your own terms.

1) What’s the best way to save into a pension if I work for myself?

The way you choose to structure your affairs - either as a sole trader, in partnership with one or more others, or as a private limited company - can influence the most effective way to fund a pension.

Let’s unpack the various types of company structure and give you some steer on what might be best.

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Sole traders, partnerships, and limited liability partnerships

Company structure

A sole trader is the simplest company structure. You run your business by yourself, which means you get to keep all the profits but are personally liable for any debts. You pay income tax on any profits, which is calculated by deducting any allowable expenses from your revenue. You also pay class 2 and class 4 National Insurance (NI).

Partnerships are structured and taxed in exactly same way as sole traders, except two or more people share the profits (although the share does not have to be equal) and they are jointly responsible for clearing debt.

A limited liability partnership is a bit like a standard partnership, but the owners and the business are considered separate entities. This means that should things go awry and the company folds, you are only liable for the money you invested in the business, so personal assets can’t be seized.

How to fund a pension

As owners of sole traders, partnerships and limited liability partnerships are taxed individually on profits, a personal pension, such as a SIPP, can be great way to save for your retirement. That’s because any pension payments you make are treated as personal contributions whether you fund them from your business bank account or not.

SIPPs have several features that can support the requirements for self-employed workers. There are a wide range of investment options, with the flexibility to pay in regular amounts or lump sums to suit your cashflow needs.

Anything you pay in each year, provided it’s within 100% of net profit or £60,000, gets an immediate 25% boost from the government in the form of up-front pensions tax relief. And if your profits exceed either £50,270 or £125,140, you might be able to claim back an extra 20% or 25%, respectively, via your tax return.

Private limited companies

Company structure

Although not technically classed as self-employed by HMRC, many freelancers and contractors choose to use the limited company structure, mainly for the tax benefits.

Private limited companies differ from the three outlined above, and in several ways. First, the company is owned by shareholders and run by directors. Your company could be single owner/director or have multiple shareholders and directors. As with limited liability partnerships, shareholders are not personally responsible for any debt.

Second, any profits are subject to corporation tax and not income tax. You also might also pay both employer and employee NI on any salary you draw.

One of the upsides is that owner/directors have the flexibility to choose how to draw from profits. You can pay yourself a salary, take dividends, or use a mixture of the two.

How to fund a pension

If you’re an owner/director of a private limited company, you have a couple of options when it comes to pension funding.

You can either fund your SIPP via the company or make personal contributions as outlined above. Which option you choose may depend on how you draw profits from the business.

But in most cases, making payments from the company is the most tax-effective way. That’s because pension contributions are deemed an allowable business expense, so provided the ‘wholly and exclusively’ test is met, so there is no corporation tax to pay, which could save your business up to 25%.

In addition, unlike drawing the money as salary, making company pension payments escapes both employer and employee NI.

A further benefit is that the 100% of earnings rule does not apply. So even if you draw a small salary and the rest in dividends for tax planning reasons, you can still pay up to £60,000 a year into a pension and save corporation tax.

If you’d like to learn more about how a SIPP can help trim your corporation tax bill, check out this article.

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2) How can I supplement my pension income?

Individual savings accounts (ISA) are a great way to save for your future whether you’re employed, self-employed, or even retired. Although pensions come with attractive up-front tax benefits, any withdrawals – except the 25% tax-free lump sum - are taxable, and you can’t access the money until your age 55 (rising to 57 in 2028).

So, it can be worth having some extra funds to dip into - either before or during retirement – that won’t trigger a tax charge. And with an annual limit of £20,000, ISAs offer plenty of scope to build a hefty pot, underscored by the 4,000 people who have become ISA millionaires.

If you’re aged 39 or under, and don’t need to access the money until you hit 60, then you can consider the Lifetime ISA (LISA). You can invest £4,000 a year into the LISA, which comes with a 25% government top-up.

3) I have pensions from previous employment, can I combine them?

The short answer is yes. One of the key benefits of a SIPP is that you can consolidate all your existing pensions to keep them under one roof. This could lower your fees, reduce admin, give you a wider choice of investment options, and there’s less chance of pensions being misplaced or lost.

But you need to tread carefully in this area. Some of your old employer pensions may contain valuable guarantees and benefits – especially if you have any defined benefit (DB) schemes - that would be lost on transfer.

It therefore can be worth taking professional advice to make sure you’re doing the right thing.

4) Is phased retirement an option for me?

The path into retirement can be less linear for self-employed workers than their employed counterparts. You may have more capacity to take on less work as time goes on, and gradually phase things out rather than pack up work completely.

If you’re nearing retirement, think about whether this is an option for you, and consider how you can use your pension savings to plug the gap should you work fewer hours and subsequently have smaller profits.

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5) Can my business form part of my pension?

If you’re confident your business can be sold for a tidy sum in the future, then by all means factor this into your plans. But be honest with yourself here – there are risks to this approach. The last thing you want is to reach retirement to find your business will fetch less than you hoped, leaving you with an income shortfall in later life.

6) Will I get the full state pension?

Self-employed workers are entitled to the full state pension just like anyone else; you just need to have 35 years’ qualifying NI contributions.

The current full state pension is £10,600. Although this is clearly not enough to rely on in later life, it’s incredibly valuable, not least because it rises every year. Getting the maximum can form the bedrock from which your retirement income is built.

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If there are any gaps in your record, then you should consider plugging them. The gov.uk website has a helpful tool that tells you whether you’re on track to get the full amount.

7) What else do I need to think about?

It’s wise for everyone to keep at least three to six months’ expenditure in an easy access account to cover any emergencies, such as your boiler breaking down.

But due to the uncertain nature of self-employment, you should consider holding back a bit more. Something closer to 12 months should provide a more than adequate safety net that can keep your company afloat should work dry up or you fall ill unexpectedly.