Retirement planning often gets pushed down the priority list for self-employed people. Many are so busy with day-to-day business activities, like winning clients and managing cash flow, that they don’t have time to think about their financial future. However, they don’t have an employer automatically enrolling them into a pension scheme, so they need to take independent action to secure a private pension.
When somebody works as an employee, they typically receive a workplace pension which both they and their employer pay into. These contributions start automatically at a certain wage threshold. In contrast, self-employed people must build their own retirement savings without employer support.
In this guide, Rapid Formations will explain how self-employed pensions work and why they matter.
Why pensions matter when you’re self-employed
Self-employed people in the UK are generally entitled to the State Pension, providing they build up enough qualifying National Insurance years. However, the State Pension alone is unlikely to provide the level of income most people may need to live a comfortable retirement. Because of this, people should consider a separate private pension to provide a larger income during retirement.
Sole traders and freelancers are responsible for arranging their own pension savings, as they don’t have access to an employer-sponsored workplace pension. Those who have gone through company formation to set up a limited company will have different pension considerations. Company directors are treated as employees of their own company for tax and legal purposes, so these business founders are not considered self-employed. Company directors can make pension contributions through their registered company, while those who operate as sole traders or freelancers will need to set up a pension separately from their work finances. Even if you do have a workplace pension, you can still choose to invest in an additional private pension.
For self-employed workers, it’s important to think seriously about actively building personal retirement savings. Failing to do so could mean relying solely on a future State Pension, which may not be enough to live how you want.
One of the biggest disadvantages for self-employed savers, from a retirement perspective, is the absence of employer pension contributions. An employee may receive contributions from both themselves and their employer each month. A self-employed tradesperson will instead need to make those contributions independently, with their pension pot building exclusively from their own payments and investment growth.
Regardless of employment status, it’s usually a good idea to think seriously about pension contributions to create a dedicated pool of money intended for later life. While it can be hard for people to see the benefit of putting money aside now, it can help provide greater financial stability during retirement.
How self-employed pensions work
There is no specific type of pension for self-employed people. Instead, self-employed people can choose and manage their own pension arrangement from the various private options available.
Typically, a pension works by someone saving money into a dedicated pension pot with a regulated provider. The provider will invest this money in the hope that its value increases. At retirement age, the pension savings can be used to provide income, which will vary depending on the value of the fund. The eventual worth of a pension depends on how much is contributed, how long contributions are made, and investment performance. Some providers will also charge varying fees for managing investments, too.
How much self-employed people save into a pension is up to them. Contributions don’t have to be fixed or made every month, as they usually are with workplace pensions. Self-employed people can choose to deposit lump sums whenever they have available funds. This may be better suited to people with fluctuating incomes. However, it can make it harder to contribute consistently. For some, it can be helpful to view modest pension payments as a monthly business expense and then top up pension funds further if business is performing particularly well.
Pension options available to self-employed workers
There are various pension options on the market. Some providers and financial products will suit certain people more than others. For example, some will offer individuals more involvement, which may appeal to those with investment knowledge. Others place much less responsibility on the saver by managing investment decisions on their behalf.
Personal pensions
Personal pensions are popular with self-employed individuals who want a relatively straightforward solution.
Providers often offer ready-made investment funds, meaning they suit people who prefer a simpler approach and don’t want to manage their own investment decisions. Typically, providers allocate more of a pension to higher-risk investments when retirement is further away in the hope of achieving greater returns. As you get closer to retirement, they will often move you to lower-risk funds. However, you can often choose to change the risk level of your plan if you want to.
When a pensions provider takes care of your investments, it’s usually convenient. You simply pay into your pension pot while the provider manages your investments.
Self-invested personal pensions (SIPPs)
SIPPs offer greater investment choice and control. These are more likely to appeal to individuals who want to select their own investments or do so with the assistance of a financial adviser.
While SIPPs do offer greater flexibility, this usually means greater responsibility. You will need to make more decisions regarding investments. Without seeking financial advice, this can be riskier.
Other retirement savings options
There are other savings products that you might want to consider. These shouldn’t be viewed as a replacement for a pension, as they work differently. However, they can provide more flexibility. If you have enough available funds, you might decide to put money aside into various types of savings options.
One example of an alternative retirement savings option is a Lifetime ISA, which is a type of ISA that can only be opened by those aged between 18 and 39. Lifetime ISA holders can invest up to £4,000 per year until the age of 50, and the government will top it up with a 25% bonus, which is £1,000 per year for those who invest the maximum. You can usually withdraw the funds without penalty from age 60, or earlier if the money is being used towards the purchase of an eligible first home worth no more than £450,000. You can hold Lifetime ISAs in cash, stocks and shares, or a combination of both. As the contributions you make to a Lifetime ISA are part of your tax-free ISA limit, you can only save in one if you’re not maxing out your ISA allowance elsewhere. However, for those who are unsure whether they can afford to save for retirement while saving to buy a home, it can be a good option with slightly more withdrawal flexibility than a pension fund.
Other savers may choose to use other ISAs for more flexibility with shorter-term fixes or invest in stocks and shares of their own choosing.
When weighing up savings options, it’s important to consider the tax implications. Pensions offer specific tax advantages to encourage saving for retirement. ISAs allow people to earn tax-free returns. Earnings on other types of savings and investments may incur tax bills.
Understanding pension tax relief
Tax relief is one of the main reasons pensions are attractive to many self-employed people.
With tax relief, a person’s contributions become worth more, as the government effectively refunds the Income Tax originally paid on this money and automatically adds it to pension contributions. For example, at current rates for a standard-rate taxpayer, investing £80 of cash into a pension fund results in a £100 contribution because the government adds the additional £20.
Higher-rate taxpayers may also be able to claim additional relief through the tax system.
Tax relief can help pension contributions grow more quickly than many people realise.
How much should self-employed people contribute to a pension?
There is no one correct answer for how much a self-employed person should contribute to a pension fund. How much they can afford to contribute will depend on their current income, outgoings, and existing savings and investments. How much they need to contribute will depend on their desired retirement lifestyle and how far they are from retirement age. Pension calculators are available to help you work out how much you should put away to receive your desired pension.
A self-employed person who starts contributing to a pension in their early twenties may choose to consistently contribute smaller amounts. In contrast, someone who hasn’t saved into a retirement fund but is nearing retirement age will likely need to make larger contributions to achieve a similar pension.
Even modest contributions can become significant over time because a longer investment period gives pension savings more opportunity to benefit from investment growth. Even if you can only afford to put away a small amount of money, it’s still worth considering a pension.
Common pension mistakes to avoid
Many self-employed people delay pension planning because retirement feels distant. However, postponing pension saving indefinitely can be a costly mistake. Starting earlier gives pension savings more time to potentially grow.
It’s also common for freelancers to only contribute to pensions when their business is performing well. However, regular pension contributions can help people maintain a savings habit.
While the State Pension exists for a reason, it’s unlikely that it will be sufficient to live on. It’s therefore important to think beyond short-term finances and take retirement planning into account, whatever your age.
It’s understandable why many self-employed people do not want to lock their money away in a pension. However, being aware of the risks of not investing now can help sole traders make more informed decisions that can benefit their financial security in retirement.
Building retirement planning into your business journey
While self-employed individuals may not have automatic workplace pensions, they do have flexibility and control over how they save for retirement.
Sole traders and freelancers can benefit from taking the time to understand their pension options. Once they find a plan that suits them, it’s usually better to start early and make regular contributions, even if they are small, rather than wait for the ‘perfect’ time when they can afford to set aside large sums. Even if you can only afford to invest small amounts right now, saving into a pension can still provide you with a more comfortable retirement.
