Employers Pension Contributions and National Insurance Contributions

A short break from my description of my attempts to build up a retirement pot to cover why employers, as opposed to employees, pension contributions are a good thing.

What makes employers pension contributions so compelling is that they are exempt both from employers and employees national insurance ("NI") contributions.  The level of employers NI contributions varies depending on contracting out but can be 13.8%.  For employee's earning more than £7,956 per annum employees national insurance is payable at 12% but this drops to 2% on earnings above £41,865.

The national insurance benefits of employer pension contributions are particularly valuable for people with their own companies which includes me.

For instance I could pay myself a salary of £10,000, with the intention of using this to pay a personal pension contribution.  But I already take a salary from the company and this uses up the employers and employees "NI free" band.  So the £10,000 salary attracts a NI charge of £2,240. (13% employers NI less corporation tax relief at 20% on the employers contribution plus 12%  employees NI).  Or alternatively I could just pay the £10,000 as an employers contribution, and pay no NI, it seems a no brainer.

Another group that can use the national insurance advantages of employer contributions are employees in their 50s.  That is the employer can pay the employee via pension contributions as opposed to salary, generating a national insurance saving for employer and employee.  The employee will have their money tied up in a pension but can access that at 55.  There may be non taxation considerations here (say redundancy is based on salary not including pension contributions) but given the national insurance benefits it should be possible to sort something out that was of mutual benefit to employer and employee.

The main downside to this is I'm not sure for how long the NI benefits of employers contributions will persist.  The Institute for Fiscal Studies has already identified it as "hard to justify" and it doesn't really to seem to "fit" with the 2014 - 2015 pensions regime.  Someone who was over 55 could just receive their salary as employers pension contribution, avoiding NI in the process.

So it might be a good idea to look to increase employers pension contributions now, whilst the going is still good.

The Limits on Pensions Saving

In previous posts I have explained that I am in the accumulation stage on my retirement planning, looking to build up a retirement pot using the tax advantages of pensions saving.

But because pension saving is tax advantaged the government doesn't want me doing too much of it and there are limits both on the amount I can save in any year and the total lifetime pension pot I can build up.  This post looks to outline these limits.  Although I work as a tax adviser I specialize in company tax and not pensions, so you need to take this as what it is, some notes on a complicated topic and not a definitive guide.

Limits on annual contributions

Annual Allowance

Every year the government sets out an annual allowance, which is the maximum amount that can be paid into pension pots by an individual in a year without an annual allowance tax charge being triggered.  For income tax the year runs from 6th April to 5th April.  The annual allowance for 6 April 2014 to 5th April 2015 2015 is £40,000.  The annual allowance is tested for the individual and not for the pension pot, so if I had more than one pension pot I would need to amalgamate contributions to all the various pots to see if I broke the £40,000 limit.

There is, however, a ridiculous complication that is the Pensions input period.  This was a new one on me but my reading of it is that if you, or your employer, are making contributions to a  defined contribution scheme then the pensions input period will just be from 6th April of one year to 5th April of the following year but the situation is more complicated if you are in a defined benefit scheme.

In applying the £40,000 allowance all pension contributions by, and on behalf, of an individual are counted.  So that includes employer contributions and any contributions someone else makes on my behalf (fat chance).  As I only have defined contribution pension pots the calculation is relatively easy, tot up the contributions made in to my pension and if they are under £40,000 then I shouldn't have to worry Link to HMRC website.  However, if you are in a defined benefit scheme then the calculation of contributions can become very complicated.

But even if my contributions are over £40,000 there is still the possibility that the annual allowance charge will not apply, as I can carry forward unused portions of the annual allowance from the three previous years.  There is an HMRC example of how this calculation works and also a annual allowance checking tool.  

Personal Contributions Cannot Exceed Income

As well as the annual allowance limit, personal pension contributions do not obtain tax relief if they are greater than the higher of 

a) £3,600

b) The taxable income of the person making the contribution.

This is a link to the HMRC material on this.  But it's important to note that this limit does not apply to employer contributions.  This is one reason why I make pension contributions via employer contributions (I have my own company), there are other reasons for using employer rather than employee contributions and I will return to these.

The Lifetime Allowance

As well as the limit on contributions there is a limit on the total amount that can be accumulated in pension pots by any individual.  From 6th April 2014 the lifetime limit is £1,250,000 (previously it was £1,500,000.)  What this means is that at certain points (generally when I start to take benefits from my pension pot) the value of my pension will be tested against this limit and if I have a pension in excess of £1,250,000 then this excess will be taxed at 55%.  As with the annual allowance the test applies to the individual and not the pension pot, so I have to amalgamate all my pension pots (including any defined benefit pots)  Personally there is no possibility that I will accumulate more than £1,250,000 in my pensions so I haven't covered this in any detail.  But there is some coverage on HMRC's website. 

As with other areas the position is fairly simple if you have defined contribution pension schemes, the value of a pot for the purposes of the £1,250,000 lifetime allowance is just the cash value of the pension pots concerned.  But it's more complicated where the pension is in a defined benefit scheme.  It seems that in this case the pension is valued at the annual pension paid on retirement multiplied by 20 plus any lump sum on retirement.  So it's relatively easy for somebody with a good defined benefit pension scheme to hit the £1,250,000 limit.

Pensions saving and Tax

As I explained in my previous posts I am in the accumulation stage of my retirement planning, i.e. I'm trying to build up a fund for my future retirement whilst still spending money on the good things in life. This post is about why I decided saving via a pension is the best way of building up a pension pot.

Although my decision is really tax driven I first had to think about non  - tax considerations, in particular: 

• I'm prepared to save via pension contributions because I'm prepared to tie up the investment until retirement age.  As I'm 48 years old I can access my pension savings in seven years at age 55. (Although if you are currently 40 or under you won't be able to access pension savings until you are 57 or maybe later.)

• I'm not interested in buy to let, as a way of building up a retirement pot.  If buy to let had appealed then I would probably have to do this outside a pension as its difficult to use pension savings to invest in residential property.

• When I get to retirement I'm quite happy to draw down my pension as a steady (ish) stream of income, I don't want to draw it all down in one go and buy a Lamborghini.  Even in George Osborne's new pension world, there is still a tax cost to taking your retirement pot in one go.  So if you aim to invest your retirement pot in, say, a business then you might want to consider a vehicle other than pensions.   

Because I'm not fussed by these non  - tax considerations I'm free to judge using a pension as a savings vehicle on its tax treatment, and I think there are compelling tax reasons to save via a pension. The UK pension system is often described as an "EET" regime this is because:

When I save money in to a pension then the income I save it from is tax  Exempt   

As money builds up in the pension it is tax                                              Exempt

When I take money out of a pension it is                                                Taxed

Although EET is a good way of thinking about tax and pensions the system is actually more generous than that.

• Firstly not all of the pension is taxed on the way out, it is possible to take 25% of the final pension pot as a tax free lump sum.  This is good news, I get tax relief up front for my pension but I am only partially taxed on the way out.  

• Secondly it is possible that retirement income will be taxed at a lower rate than earned income.  (This isn't a factor for me as I earn via my business that pays tax at 20% but may be relevant if you are employed. Then you may be able to save in pension,  reducing  income currently taxed at 45% or 40% and pay tax at 20% when you draw the income down in retirement).

Just to prove to myself that this all works I did a little numerical example that compares ISA investing with pension investing.  Assuming that the individual doing the saving pays tax on income earned now at 40% but suffers tax on future pension income at 20% then saving in a pension rather than an ISA can increase the income in retirement by 25%. I have deliberately left national insurance out of the example, as that will be the topic of a later post.

(Hopefully) You can download the spreadsheet from the link below.

ISA vs Pension

In my situation the figures don't look quite so good  (I maybe get 10% more income from saving via a pension than in an ISA compared to the 25% + for a 40% tax payer) but it still seems clear that pension saving is the way to go.

There are however a couple of drawbacks from saving via a pension.

• Although money builds up in a pension tax free this tax exemption is not complete.  If you invest in equities then it is likely that the companies you invest in will have already paid tax on their profits.  At one stage pension schemes could claim a tax credit from the government when they received UK dividends to compensate them for the tax the company paid on profits, but Gordon Brown stopped all that.  Although this is a bad thing, ISAs are similarly unable to claim back  tax paid on company profits so it doesn't change the comparison.

• Although the tax rules for pension saving are generous there are restrictions on the amount that can be invested in a pension and the total amount of pension saving that can be accumulated.  My next post will be on these rules.

Pensions and Saving

This follows from my post on the stages of retirement, I identified the first stage as accumulation.  For me the accumulation stage starts when you are old enough to be prepared to commit to long term saving even if it means having money tied up in a pension but you are still  working full time.

My financial goal in the accumulation stage is to maximize the pot that I have available for retirement whilst minimizing the bad things in life.

The bad things are

• Work that isn't congenial

• Cutting back my spending on things that I enjoy

Obviously it's possible that I reach a point where I just have to choose between good things and bad things. I might  just have to take on a bit of work that I'd really rather not do, or cut spending on "luxuries" in order to increase my retirement provision.  But I don't think there's any point blogging about that, the trade off of competing wants is a personal choice, what works for me might not work for you.  But if I come across something that boosts my pension pot and doesn't give rise to a corresponding bad thing then that probably is worth telling you about. 

To start with a basic point: saving is better than earning.  Earning is always likely to involve working and there is always the potential for work not to be congenial.  In my opinion once I'm working more than a certain number of hours a week, work is always uncongenial.

Secondly, I'm going to spend money for as long as I live, but I'm not going to earn money for as long as I live. So finding £1 of savings will have more life time value than finding a way to earn £1 more.

Finally, if I earn money I'm going to pay tax on it, but if I save money that's tax free.

Just to give you an idea of the second and third effects: I have rigged up a spread sheet to forecast my income in retirement.  If I show my income increasing by £1,000 per year until active retirement it increases my net lifetime income minus lifetime spending figure by £14,000. Pretty good.  But if I can save £1,000 then that increases my lifetime income minus spending by £37,000.

So last year I had a look at my spending.  I don't want to say too much about this, There are tons of sites on the internet that tell you how to save money although quite a lot of them read like Viz top tips. But some things that I did find useful were:

• Recording what I spent.  Fairly obvious point but hard to save without it and much easier to do now that 85% of spending is on a card.  It also shows how small spends can mount up, for instance I was spending over £1,000 a year on take away coffee.

• Walking. Walking is the looking forward to retirement blog, top tip.  It saves money, its the most enjoyable way of getting around and it helps your health.  Win win win.

• Stop spending money on stupid things.  Its unlikely that you are this stupid but I found I was spending £20 a month on contact lenses when I had laser surgery on my eyes 4 years ago.   And there were a few other long standing orders that got given the heave ho without reducing my quality of life one iota.

• Look out for commodities.  I class a commodity as anything where exactly the same product is sold by different providers. Accordingly you can reduce spending without sacrificing anything.  A good one for me was broadband, I switched from Virgin to Sky but when I phoned up Virgin to disconnect they then, magically, beat Sky's offer.  Utilities is another good area.

• Something I did, that I wouldn't do again, was spending less money on my property.  It became apparent that I was going to have to reverse some of the cuts else I'd end up living in something that was falling down and unpleasant to boot.  I'd characterize my mistake as confusing investment with pointless spending.

And, on that bombshell I'll finish.

Next week I'll do a  post on some tax and pensions points.