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Working for yourself carries many benefits, including the freedom to work when and where you choose. Yet one disadvantage is that you do not have an employer who offers you a workplace pension, and who contributes into it. For self-employed people, therefore, you have two broad options to consider alongside your state pension for retirement planning – a personal pension (e.g. a Self-Invested Personal Pension, or SIPP) or an ISA.
Below, our financial planning team at Cedar House offers some thoughts on the strengths and weaknesses of these two investment vehicles for self-employed people. We hope you find this content useful. If you’d like to find out more or discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or enquiries@cedarhfs.co.uk
Broad considerations for the self-employed
Firstly, it’s important to recognise that neither an ISA nor a pension will naturally offer you better investment performance. This depends on a range of factors, including the investment strategy you pursue within your pension or ISA. Secondly, these two vehicles are not mutually exclusive. It may be that you want to open a pension and an ISA, contributing to both over time. Thirdly, it is important to start saving for retirement as soon as possible. The earlier you begin, the more time you have for compound interest to work its power on your long-term savings – often leading to exponential growth in the final years prior to retirement.
ISAs for self-employed people
There are different types of ISA including Cash ISAs, Innovative Finance ISAs, Stocks & Shares ISAs and Lifetime ISAs. The latter two are likely to be most relevant to discussions on planning for retirement, since they allow you to commit your money to assets with higher growth potential (e.g. equities). The Lifetime ISA also offers a strong financial incentive by offering a 25% boost to savings worth up to £4,000 per tax year – representing a potential “top up” of £1,000 per year from the UK government.
You can put up to £20,000 into your ISA(s) per tax year. Any dividends, capital gains or interest generated within your ISAs will be free from tax. Over time, this can let a self-employed person build a sizable retirement pot which is shielded from the taxman. Over 10 years, for instance, a business owner could, theoretically, build a nest egg worth £200,000 – setting aside any growth from investments, as well as the 25% government boost. You can also start withdrawing money from your ISAs at any time. Since there is no age restriction, this means you could retire early if you want to and are able to. There is also no cap on the overall amount you can save into your ISAs, which could allow you to build a large stash of wealth for a very comfortable retirement.
Personal pensions – an alternative
ISAs do have their drawbacks, however. Firstly, most income put into an ISA has already been taxed at, say, 40% (if you are on the Higher Rate). Secondly, assets inside an ISA are not free from inheritance tax (IHT) when you die. This could significantly erode the wealth you may hope to pass on to your children one day.
Pensions address these issues. Whilst you cannot claim pension contributions as a business expense as a sole trader, you do gain access to tax relief on the amount you put in – equivalent to your highest rate of income tax. For business owners earning over £50,000 per year (i.e. the threshold for the Higher Rate), this can be a strong reason to consider a pension. The reason is that the 40% tax relief you would receive on your pension contributions would be better than the 25% government boost offered by a Lifetime ISA. You can also put more into a pension scheme each year compared to an ISA. The latter restricts you to £20,000 per tax year, whilst you can put up to £40,000 into a pension (or up to your earnings for the year – whichever is lower). You can also pass on any money in a defined contribution pension to your heirs free from IHT.
However, business owners do also need to weigh the drawbacks of pensions. Presently, you can also access the funds from age 55 (rising to 57 in the future). This may undermine plans to retire early if your business is successful and you decide to sell. You also need to consider the lifetime allowance on pensions, which limits you to saving up to £1,073,100 in total. Pensions can also be inflexible when it comes to the range of investments available to you. There can be options to widen your choice options – such as a SIPP – but these can come with a higher price tag (e.g. in the form of higher investment management charges). A good financial adviser can help you survey the wider marketplace and find some good candidates for your retirement plan.
Conclusion
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or enquiries@cedarhfs.co.uk