Pension options for the self-employed

Last week, a report found that millions will be faced with a “bleak old age” because of the paucity of pension provision.

The report, from the Workplace Retirement Income Commission, focused on the number of employees who are not contributing to occupational pension schemes.

But it also raises important questions about the provision of pensions for the self-employed. Of course, self-employed people do not have access to an occupational pension scheme. Instead, they are required to make their own provision for retirement.

The range of pension alternatives on offer can be dizzying. So what are the main options, and how can they help you save for retirement?

How do personal pension plans work?

In order to top up your State Pension, you might consider contributing to a personal pension plan. This type of pension operates on a ‘money purchase’ basis. This means that you make contributions, which are then invested by a fund manager. The final size of the fund depends on the amount you contribute, and how well the investments perform.

You can buy a personal pension from a range of High Street banks, or from many specialist providers. They are available to those under the age of 75, and can normally be cashed at any point after you reach the age of 55.

What about stakeholder pensions?

Stakeholder pensions are particularly popular amongst the self-employed. Stakeholder pensions are a type of personal pension scheme (and therefore operate on the same money purchase basis), but they must also conform to a set of legal requirements governing things like affordability and flexibility.

The rules by which stakeholder pensions must abide include:

• Fees must not exceed 1.5 per cent of the total size of the fund per year during the first ten years, and 1 per cent a year from year 11.
• Holders must be allowed to contribute from a minimum of £20.
• Holders must be able to transfer their fund, and start, stop, or change their contributions, without incurring a penalty.

What about SIPPs?

Many self-employed people prefer to take a more active interest in the welfare of their pension fund. If you are one of those individuals, you might consider a Self Invested Personal Pension (SIPP).

Under a SIPP arrangement you can choose how your money is invested. You might choose a range of different investments, including commercial property, unit trusts, equities, securities, and hedge funds. You can manage these investments yourself, or you can pay a professional to do it for you.

How are they taxed?

If you are a basic rate taxpayer, your pension provider will be able to claim relief on your contributions at a rate of 20 per cent. This will then be added to your fund. In practice this means that for every £10 you contribute you will receive an extra £2.50 in relief – because your contribution represents 80 per cent of your total entitlement.

If you are a higher rate or additional rate taxpayer, you will be able to claim the difference back through Self Assessment.

There are limits to the relief you can claim. You will receive relief on contributions up to £3,600 or 100 per cent of your earnings, whichever is greater. But this is subject to an Annual Allowance, which is set at £50,000 for the 2011-12 tax year. You can still make contributions above this level, but they will be subject to a tax charge.

What is an annuity?

When you retire, you are entitled to take as much as 25 per cent of the value of the fund as a lump sum. This is tax free. The rest of the fund must normally then be used to buy an annuity – unless you have invested in a SIPP, in which case you can continue to receive an income from the fund itself.

An annuity is the tool that converts your pension fund into an income. Once you have bought your annuity, you will receive an income from it for the rest of your life. You can buy one at any point between the age of 55 and 75, subject to restrictions imposed by your pension.

There are various types of annuity. You might choose, for example, to receive a guaranteed steady income for life. Alternatively, you might choose to buy an annuity in which the income is linked to a specific investment. Your choice will obviously depend on a range of factors, including the other financial provisions you have in place.

It is important to understand that you do not have to buy your annuity from your pension provider. Instead, you may be able to get a better deal by shopping around.

Your choice of pension can have a significant impact on your future financial situation. It is vital that you take personal, independent, professional advice before making a decision.

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