For many individuals, pensions are not a priority. Pension contributions may be deferred or suspended due to financial constraints. However, significant tax advantages are associated with contributing to a pension plan, and early initiation of contributions maximises potential benefits.
The workplace pension auto-enrolment scheme, implemented in 2012, has increased participation in retirement savings. Nonetheless, concerns persist regarding the scheme’s limitations for self-employed individuals, including franchisees, who may lack traditional employer contributions.
Despite this, self-employed individuals, franchisees, and contractors have a few options for pension savings, with access to significant tax benefits. This article will explain the tax efficiency of pension fund contributions, the advantages of your contributions as a business owner, and addresses common questions regarding pensions, particularly for business owners like franchisees.
Definition of a Pension
There are three principal types of pensions:
- Defined Contribution: A pension fund based on contributions from the individual or a combination of the individual and their employer. This is a popular option for franchisees.
- Defined Benefit: Typically employer-provided, calculated based on salary and tenure. Employee contributions may also be required.
- State Pension: A state-provided pension funded by national insurance contributions.
People earning over a certain amount must pay National Insurance towards a state pension. However, both defined contribution and defined benefit pensions are also tax-efficient ways to save for retirement. This applies to both employees and franchisees.
Contributions are placed into a pension fund or multiple funds, managed by a pension provider. The provider invests these funds until withdrawal, aiming to increase the fund’s value. Investment risks, including potential losses, should be acknowledged.
However, investment gains within the pension fund are tax-exempt, as are contributions. Access to the pension fund is generally restricted to the age stipulated by the provider, typically 55, which differs from the state pension age.
Importance of Pension Fund Savings
Saving into a private pension fund, whether through a workplace or personal scheme, is essential. Reliance on the state pension alone is unlikely to adequately cover retirement expenses. This is particularly crucial for self-employed individuals and franchisees.
For the tax year 2024/25, the full state pension is £221.20 per week, accessible at age 66. The state pension age is scheduled to increase to 67 between 2026 and 2028, and to 68 between 2044 and 2026. Early retirement necessitates a private pension.
Pension fund savings enhance financial security in later life. A transition to reduced or ceased earnings is anticipated. Franchisees, in particular, may experience fluctuations in income over time.
While pension receipt does not mandate retirement, and concurrent employment is possible, a robust pension fund facilitates alternative pursuits without financial concerns. This is important for franchisees planning for their future after their business operations.
Tax Advantages of Pension Fund Contributions
Financial advisors often recommend pension contributions for tax optimisation. Numerous tax advantages are associated with pension contributions. For high-net-worth individuals in higher tax brackets, pension planning enhances retirement savings and reduces tax liabilities. The following are five tax advantages:
- Expansion of Basic Rate Income Tax Band: Contributions extend the £50,270 basic income tax threshold, reducing higher-rate taxation.
- Government Pension Top-Up: A 25% government contribution is added to pension savings. Higher-rate taxpayers receive additional tax relief.
- Tax-Free Investment Growth: Investment gains within a pension fund are tax-exempt.
- Inheritance Tax-Free Transfer (subject to future changes): Pensions may currently be passed to beneficiaries inheritance tax-free under certain conditions. Rules may change in 2027. This is valuable for franchisees planning to leave their business and assets to their family.
- Tax-Free Lump Sum Withdrawal: 25% of the pension can usually be withdrawn tax-free at retirement.
Pension Fund Contribution Explained
Workplace pension schemes, mandated for employers, facilitate contributions. Employees must contribute a minimum of 5% of salary, and employers a minimum of 3%. Self-employed individuals and franchisees may establish private pensions.
Pension Account Limits
Multiple pension funds are permissible. Diversifying your pension fund contribution can mitigate risk. Management complexity may necessitate consolidation.
Since the 2023 Spring Budget, the Chancellor abolished the lifetime pension allowance which previously allowed you to put in a maximum of £1,073,100 over the course of your entire lifetime. Doing this encourages people to work for longer in order to keep putting savings into a pension scheme, without being disqualified for doing so. You can take advantage of this by making pension contributions as early in life as possible.
Early Pension Withdrawal
It is possible to withdraw funds from your pension early (before the age of 55), but there are heavy tax disadvantages to doing so. We heavily advise against doing so, unless under specific circumstances. Early withdrawal (before 55) incurs substantial tax penalties and is generally discouraged.
Pension Taxation
A 25% tax-free lump sum is typically permissible upon retirement. Withdrawals exceeding the personal allowance are subject to income tax.
If you are only receiving income from your pension, your tax will be deducted at source (similar to how employers deduct your income tax from your wages before you receive it). If however, you have other sources of income, then you will need to declare your pension income tax due through a self-assessment tax return.
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