How contractor pensions are being shaken up

With the many changes affecting saving for when your contract days are over being buried in the dull-sounding ‘Taxation of Pensions Bill,’ contractors may not have read about what’s probably the most exciting news ever to break for nest eggs, writes ContractorMoney’s Tony Harris.

For the first time in history, a pension offers a contractor both upfront tax savings when they contribute AND the scope for generous tax savings when they decide to access an income in retirement. No longer are you forced to take out an annuity, nor are you restricted on how and when you take out 25% of your pension as a tax-free lump sum.

The cherry on top of this feast of developments that will make a pension both very flexible and extremely tax-friendly is that you can now start to seriously consider your pension as a means of estate planning, because your family will no longer pay a hefty tax bill when they inherit your nest egg.

The following sections detail the major changes to pension rules that contractors need to know about:

The ‘Bank Account’ pension

Unveiled in Parliament last week, the bill means that contractors will now have the option of drawing multiple lump sums direct from their pension fund known as ‘Uncrystallised Lump Sum’ payments.

This allows you to take ad-hoc payments without the requirement of drawing all of your 25% tax-free lump sum in one go. The lump sums could be part taxable income/part tax-free cash and will be similar to what is currently available via ‘phased’ retirement – the main difference being there is no cap on the income. It is important to note that this is not allowable from drawdown funds however, so contractors that are already retired and in drawdown may not be able to benefit.

This new pension rule is being dubbed the ‘bank account pension’ by the media because it will allow complete flexibility to contractors wishing to take several smaller withdrawals rather than a single lump sum. It will therefore resemble a savings account but with tax incentives.

And those who like to minimise their tax take read this: There will now be tax-planning opportunities a plenty as our team could, for instance, draw down just enough of the non-tax free element of your fund each year to remain within the personal allowance. This would mean that, with proper planning, you could enjoy an entirely tax-free annual pension income in future!

The Lamborghini pension  

Post-Budget 2014, contractors have now been given the ability to access their entire pension fund as a lump sum. The maximum amount that you can release tax-free remains at 25%, but you can now withdraw all of the remaining funds which will be subject to income tax at your marginal rate. This will be particularly helpful for contractors with small pots and will effectively end the previous rules around taking benefits under the so-called ‘triviality rules.’

There has been speculation, rather insultingly in my view, that retirees may draw out every penny and blow the money on a supercar, then become a burden on the state. Well, after 18 years of giving financial advice specifically to the UK’s contractor community, I’m happy to report that anyone responsible enough to take advantage of the upfront tax breaks and build up a pot for their future financial security is usually very, very unlikely to then blow the lot. Even the most die-hard petrol head would, after all, be mindful of the need to budget for the tax, insurance and fuel bills of running that supercar! So long term income needs will still be paramount in the minds of retirees, but the new flexibility will certainly be leveraged to pay off interest-only mortgages or other debt or perhaps invest in a lifestyle business to ease the way into early retirement.

The cap-free pension

In the past, those contractors who were unhappy to hand all of their money to an insurer to buy a rigid annuity at retirement could opt for ‘capped income drawdown’ instead, where the money remained invested and an income could be drawn off as required. Income limits were linked to Government Actuary Department interest rates, which were essentially very close to annuity rates and governed by your age, sex and 15-year gilt yields. You now have the option to draw any level of income you would like to suit your circumstances.  

To allow ‘flexible drawdown’ access, whereby the entire fund could be en-cashed, the requirement was previously that you needed to have a minimum of £12,000p/a secure pension income. This will now be abolished, which will come as fantastic news for contractors who have a smaller, ongoing pension.

If you are already in capped drawdown, you will have the option to convert to the new flexi-access rules if you wish. However, by doing so you would lose your current annual allowance of £40,000 as it would revert to the new £10,000 allowance for contractors who enter the new flexi-access arena, or take the Uncrystallised Pension Lump Sum.

The generational game pension

Death benefits post-April 2015 will be tax-free for any contractor who is under the age of 75 at the time of their death. This tax-free status will include any benefits that were previously in a drawdown arrangement, which were previously taxed at 55% if inherited as a lump sum. Post 75-years-old,  pension benefits will be taxed at the dependant’s marginal rate of income tax.

Further good news is that a dependant will be able to draw any death benefits under the new flexible rules, so it would not have to be taken as a one-off lump sum, which allows your loved ones the flexibility of using your nest egg as and when they need an injection of capital. This will be especially beneficial for your family if you pass away after age 75, as they could then reduce their overall tax liability on the benefits.

If you choose to purchase an annuity, they will have no cap on guaranteed periods post-April 2015. This means that potentially a dependant could continue to receive the full income, rather than a reduced pension on your death, for a much longer period. Any annuities with capital protection will pay out a tax-free lump sum benefit before the age of 75.

These changes to the way in which a pension is inherited and taxed will make a significant difference to contractors hoping, understandably, that their hard-earned nest egg will end up in the right hands if they are no longer around. So there are now real tax benefits at both ends of the pension timeline.

Take advantage of the new flexible pension rules

With this massively increased flexibility surrounding how you access your pension funds, there has never been a better time to explore the opportunity for upfront tax savings on your pension contributions today. You can still invest up to £40,000 per tax year either personally or via your limited company, and the tax saving could be the equivalent of up to 64% which means for every £100 you invest, you only actually pay £36 and the taxman pays the rest. You can now even utilise your pension to leave a lasting legacy for your time contracting, which will provide an income for retirement and could leave a substantial inheritance for your loved ones.

Final thoughts

Contractors should be under no illusion – the post-Budget 2014 changes to pension rules explained in this article represent what is arguably the biggest upheaval in the history of pensions. As I’ve outlined, you can now take your entire pension as a lump sum; take the tax-free cash AND pass on your pension to your loved ones, also tax-free.  

The long and short of the pensions revolution is that investors have been given the opportunity to take complete control of how they access their nest egg. This has resulted in a renewed eagerness among contractors to discuss what had, to some, become a discredited investment option. As we’re now increasingly telling contractors: with the right guidance you can make your investment fit perfectly with your individual tax planning needs, both now, at retirement and even after your death.