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Pensions – A lucrative tax break for Contractors

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After IR35, MSC clampdowns, income shifting court cases and corporation tax hikes, Contractors may have all but given up on finding a way out of the tax-man's grasp.

However, there is a completely legal way that you can reduce the tax take on your income to virtually nothing…Tony Harris from specialist IFAs ContractorFinancials explains all.

Despite lengthy battles between HMRC and the PCG over IR35, the new tax regime is now firmly entrenched. Some Contractors have been able to show that they work outside of this tax regime but those who are caught within IR35 now stump up employers and employees National Insurance on at least 95% of their income as a result of the high salary that they are forced to draw. Those that have sought an easier life in an umbrella company have these extra deductions made via their payroll.

Even those Contractors who found temporary respite via a Managed Service Company are now being affected thanks to the crackdown on these vehicles.

An escape route

It could well seem that there is nowhere else to hide from this onslaught but all is not lost. As pension advisers we are increasingly helping clients to significantly reduce their tax bills using pension contributions.

A surprise victory over the taxman!

Pensions simplification (known as 'A' Day) which came into force in April 06 now means that an employer pension contribution (i.e. one that is funded from the company account rather than personally by an employee) is no longer restricted by a rigid percentage of salary level and instead is simply limited by a set annual allowance. This is a major result for Contractors who had typically paid themselves tax efficiently small salaries which in turn had greatly restricted what could be invested towards future retirement plans.

In reality a Contractor working through his or her one-man limited company should have very little to fear now and will be able to fully exploit the massive tax saving possibilities afforded by the lifetime pension limit of £1.6 million.

Whilst matters are not so cut and dry for a company with numerous employees and various sources of income, a one man limited company contractor is responsible for the total earnings of his company and it now seems clear that HMRC take a relaxed view of how you choose to remunerate yourself, whether that be salary, dividend or pension and any combination of the three.

The pension contribution would be transferred into the pension gross, without any deduction of income tax or NI and with no benefit in kind considerations to worry about. As such this represents a very effective way to transfer funds from company to personal hands and the money remains invested in tax efficient environment to grow towards providing a retirement income for you.

Case studies

In reality your household budget will dictate how much scope you will have to exploit this tax break but we are speaking to clients on a daily basis who wish to maximise what they can do on this front.

• Perhaps you can live off savings now and plough a significant chunk of your income into pension instead of drawing it as taxable dividends or salary

• You may be able to use a working spouses salary to pay the monthly bills rather than pay 40% + income tax on your contract rate
• Maybe you could decide to drawdown on retained profit to pay the bills and invest ongoing income directly into your pension.

• You could use short term interest free or low rate finance (say via a mortgage drawdown facility) to pay bills now and maximise this years scope to cut personal and company taxation

• Suspend ISA or similar investments and mortgage overpayments which must all be paid from net income so that you can maximise the far greater immediate tax breaks available by reducing salary and dividends and placing the funds in your pension instead.

Pensions for a new age

To further enhance the appeal of pension investment you now no longer need to purchase a rigid annuity and have far greater flexibility as to how and when pension benefits must ultimately be taken. These factors combine to make pension investment a far more attractive prospect than seemed to be the case before 'simplification'.

Given the various challenges that face composites and MSCs, the closer scrutiny of expenses that many contractors look to face in future and the new income shifting rules, these new pension opportunities couldn't have come at a better time. A stampede back to Personal Service Companies could be the result of this increased scope to make employer pension contributions because pensions could very well represent the most tax efficient method of transferring substantial funds from contract and into personal hands.

For once Contractors look set to be able to benefit from HMRC rules instead of having to pick up an increased tax.

Tony Harris is Managing Director of ContractorFinancials, an Independent Financial Adviser that specialises in finding financial solutions tailored to your needs as a Contractor.

© 2009 All rights reserved. Reproduction in whole or in part without permission is prohibited.
Image: Arrow of Sunlight. by seeks2dream

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