Do pensions reduce tax for the self-employed?

Those in standard employment join a workplace pension via automatic enrolment. The story is different for those that are self-employed. With no employer providing enrolment automatically, the impetus is on the self-employed individual to arrange their own pension scheme.

This explains why those self-employed are three times less likely to pay into pensions compared to employees. This is a major issue because self-employed workers are placing their retirement in jeopardy without a pension pot in place. Furthermore, they are missing out on numerous benefits gained from having a pension plan.

Pensions are one of the most tax-efficient ways to save for the future but do pensions reduce tax for the self-employed? Let us explore the answer.

Do pensions reduce tax for the self-employed?

As mentioned, there are various benefits available to those with self-employed pensions. One of the biggest is that, yes, it does provide tax relief in various different ways.

This is most notable when it comes to government top-ups. If you are a basic rate taxpayer, you will currently be taxed at 20% of your income. However, whenever you contribute to your pension, there is a refund on that tax percentage.

For example, say that you contribute £2,000 into your pension pot for the year. The government’s top-up scheme means that an extra £500 would be added to your pension contributions, making it £2,500 in total. This is because 20% of £2,500 is £500, and this is the tax that is added to each contribution. Think of it as a healthy 20% bonus.

Of course, this isn’t the only financial benefit you receive on top of your contributions. You also receive compound interest for your pension. This means the longer you have a pension, the more it will ultimately make from both interest and tax relief.

Claiming tax relief on pensions for the self-employed

If you’re self-employed and a basic taxpayer, good news. You don’t have to do anything extra. The tax relief benefits mentioned above are automatically applied to your pension pot.

The situation is different when operating in the Higher Rate tax band. You are responsible for claiming additional relief, which can be an additional 20% towards the original 20% tax relief. As this adds even more to your pension contributions, it is worth doing. All it requires is that you claim this through your self-assessment tax return.

Points to remember with tax and self-employed pensions

There are plenty of tax-related benefits that come from a self-employed pension plan. However, there are some points to keep in mind.

One is that you cannot claim pension contributions as a business cost. These contributions do not have any impact on the profits you make when self-employed, so they are not classed as a tax-deductible expense.

In addition, you also cannot gain unlimited tax relief from your pension contributions. The government has currently capped this at £40,000 per year, however this will be raising to £60,000 after April 2023. Alternatively, any contributions to your pension cannot exceed 100% of your annual income or you will be taxed heavily for the additional contributions.

Operating as a limited company

There are more pension options available to those that operate as a limited company rather than a sole trader. For instance, while a sole trader still has plenty of pension plans to choose from, they can only be a personal pension. A limited company, however, is given greater flexibility with creating a pension scheme.

Limited companies can also function as a more tax-efficient entity. By arranging pensions for employees, limited companies naturally make larger pension contributions overall. The result of this is a company can reduce its taxable profits and, at the same time, its financial liability towards Corporation Tax.

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Disclaimer 

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