How pension tax relief works with fluctuating income
This content is for information purposes only and should not be taken as financial advice. Every effort has been made to ensure the information is correct and up-to-date at the time of writing. For personalised and regulated advice regarding your situation, please consult an independent financial adviser here at Castlegate in Grantham, Lincolnshire or other local offices.
There were 1.9 million freelancers in 2022, comprising nearly half of the UK’s 4.39 million self-employed people. The latter is slightly down from the peak of over 5 million in 2020 (during the onset of the pandemic), but certainly up from the low of 3.2 million in 2000.
Being self-employed brings many wonderful benefits. However, one of the challenges to navigate is that your monthly income can be unpredictable. This can make it difficult to pay the same regular amount into a pension and track your progress towards your retirement goals.
Below, our Lincolnshire financial planners offer some ideas about how to navigate pension planning effectively when your income changes frequently. We hope this is useful to you. To discuss your financial plan with us, please get in touch to arrange a no-obligation financial consultation, at our expense:
01476 855 585
info@casfin.co.uk
Why can a fluctuating income cause pension problems?
When an individual relies on a salary, their monthly income is often very stable (unless, say, they are a salesperson who also receives a commission). This is helpful for pension planning.
However, the picture is often more complex for a self-employed person. Firstly, since you are your own boss, you are not obliged to pay into a pension under the UK’s auto-enrolment rules. Instead, you may need to open your own private pension and contribute to that.
Secondly, you cannot rely on an employer to calculate your pension tax relief for you and submit information on your behalf to HMRC. Instead, you must track all of the relevant data and file a Self Assessment Tax Return by the relevant deadline each year.
A third potential issue concerns the “tax year crossover” scenario. For example, suppose a temporary worker (e.g. an IT contractor) normally gets contract extensions every three months and they want to maximise their £60,000 annual allowance before the tax year restarts, on 6 April.
However, if their next contract is not renewed before this date, they may not be able to pay as much into their pension as they want for the concluding tax year – missing out on the tax relief.
A fourth possible issue is market timing risk. Suppose your income is quite high in the early months of the year – leading you to put more into your pension (since your contributions are a percentage of your income). At this time, the markets fall unexpectedly, leading to lower performance in your pension investments.
However, in the later months, your income stalls (due to wider economic conditions) and your total monthly contributions also fall. At this point, the market starts to recover. Over the last twelve months, therefore, your contributions were not evenly spaced out.
Indeed, you contributed more to your pension in the periods of depressed asset prices; less during the better months. Assuming this was not a deliberate strategy (e.g. a value investing approach), this could inadvertently lead to unexpected performance outcomes.
How can I plan for my pension?
As a self-employed person, it is important to remember that you are entitled to the State Pension just like everyone else. Also, despite the fact that you cannot receive employer contributions to your pension pot, you can still claim tax relief within the limits of your annual allowance.
To mitigate market timing risk, monthly pension contributions are often a good idea for self-employed people – even if your income is unpredictable. For instance, suppose your monthly contribution target is £300. In Month One, your income is high and so you could put in double (£600) if you wanted to.
One option is to do just that. However, another idea might be to set £300 aside for a future month in case your business income stalls. This helps you to maintain a “pound cost averaging” approach to your contributions and mitigate the impact of a market crash on your portfolio.
If you find yourself in the “tax crossover scenario” above, bear in mind that the “carry forward” rules for pensions let you use any unused annual allowance from the previous three tax years when claiming tax relief. Just be aware that the annual allowance has changed to £60,000 in 2023-24 – up from £40,000 in previous tax years. So, seek advice if you need clarity.
As a parting thought, be careful not to assume that, as a self-employed person, your business will be your pension (i.e. you will sell it when you retire). If your business goes bust, then you may not just lose your livelihood but also your retirement fund.
It pays to have a pension plan running alongside your business. Speak with a financial planner to fully explore the options about how to do this effectively.
Invitation
If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
01476 855 585
info@casfin.co.uk
