Are you stuck between a rock and a hard place for a suitable retirement savings plan?

If you’re based in the UK, the choice between an ISA  or a private pension for self-employed individuals can be a tough call to make.

And this is even tougher post 2020 pandemic time.

The Other Half – Employees

The comfort of a regular income, a secure employer and pension contributions being made on your behalf is the ‘cushty’ reality for many employees. 

Yes, employees have the day to day ‘politics’ that goes with the territory of working for an employer but they dont’ have the responsibility of planning for their retirement freedom in the same way as those relying on self – employment do!

Firstly, let’s take a look at making pension savings for the self-employed.

Just like everybody else in the UK, you are able to receive tax relief on UK earnings up to a limit of £40,000 per year. So for higher rate tax paying self employed individuals 40% tax relief is available.

That’s definitely something to take advantage of.

In reality many self employed are not higher rate taxpayers but basic rate tax- payers. But don’t despair yet.

This still means that tax-relief is available at 20%.

Pension or ISA for the Self-Employed? Income Considerations

For many self-employed income fluctuates month to month and year to year. There may be an established pattern of income but in many instances income distribution is sporadic.

Therefore, this can make regular savings and the commitment associated with this a little difficult.

Declared income to HMRC may also be a little different to actual income, which is especially true for those that still receive the bulk of their income in ‘cash’ form. Whilst all income should be declared the temptation not to (in cash based businesses) is well documented.

Due to this, the limitation faced by many self – employed, in terms of pension contributions is a little like borrowing limitations with showing a low income.

Generous Tax relief will only be provided on declared income.

Pension or ISA for Self-Employed – Restricted Access?

As an alternative to a pension opening an ISA is very straightforward and the money can potentially grow in a tax-efficient manner (slightly toungue in cheek due to Zero interest rates in 2020!).

Withdrawing money from an ISA is also very straightforward and is tax-free.

In comparison once money is invested within a pension arrangement it cannot be taken out until you’re at least 55 years old (rising to 57/58 by 2030).

Is this a problem?

The whole idea of making provision for retirement is that funds are available in retirement.

The temptation to ‘dip’ into an ISA account savings may be hard to resist, especially if the ‘temptation’ is more through necessity than anything else (LISAs are slightly different – more below). 

Unlike an ISA money contributed to a pension arrangement cannot be accessed so it’s effectively ‘invested’ until you reach 55.

Pension or ISA for Self- Employed – Investments and SIPPs

Starting a personal pension usually means any money contributed will be invested in a specific way. There will usually be a limited range of investment funds to choose from a mainstream pension plan.

A form of personal pension called a Self Invested Personal Pension (or SIPP) were  popular, especially amongst the self-employed. These types of pension plan (or wrapper) offer the choice of a much wider range of investment options. 

But before you think about that you must be honest with your investment experience and attitude to risk as the decisions of what to invest in and when will be your responsibility.

Why is caution urged?

Because without investment experience there is a much higher likelihood of making poor investment decisions. Investment risk is a broad ‘catchall’ and is usually demonstrated by experience. 

A classic Risk/Return saying is: 

Higher risk means potentially higher returns. But note the ‘potentially’ bit.

Capacity for loss is your ability to absorb loss from investments and its impact on your overall financial well being.

Think of it like this.

If you lose what you invest will it have a major impact on your overall financial position? Or another way is to imagine you have £10,000 and lose it all. For somebody with £100,000s this is less problematic!

SIPPs were originally for those with investment experience that wanted to ‘self invest.’

In summary, veer on the side of caution if you have no investment experience. A standard type of pension with low charges such as a flexible access drawdown pension may be more suitable.

Likewise, with an ISA account a broad range of investment options are available. A stocks and shares ISA, again, may potentially provide great returns, but it may not. 

Pension or ISA for Self-Employed – Lifetime ISA

The launch of the Lifetime ISA or LISA was without much fanfare.

It’s basically a type of ISA account aimed at younger individuals/couples so they can either make a house purchase or use the funds for a retirement fund.

The main advantage of a LISA is that a 25% bonus is given by the UK Government. 

The maximum contribution in a year is £4,000 plus the £1,000 from the Government, so £5,000.

So free cash from the government! That’s got to be worth grabbing.

Some conditions that apply include if for retirement use:

You must be at least 18 and no older than 40 and contributions can be made up to the age of 50.

You cannot withdraw any money until the age of 60. If you do any bonuses received plus the returns on these bonuses will go back to the government.

Some conditions that apply include if for first property purchase:

Funds from a LISA can be put to use at any point as a deposit for a first home costing no more than £450,000.

Note: This cannot be put to use for the purposes of a buy to let!

Any amount saved to a LISA forms part of the overall £20,000 (2020/21) limit.

Therefore, if the maximum contribution is made to a LISA it’s possible to stash another £15,000 in a Stocks and Shares ISA, Cash ISA or Innovative Finance ISA. 

Cash ISA

Money can be invested into deposit accounts including a National Savings and Investments (NS&I) direct account. 

Stocks and Shares ISA

Invest in shares, corporate bonds, gilts, single life assurance policies, UK-authorised Unit Trusts, UK listed investment trusts.

Pension or ISA for self – employed – Summary

Ignoring cash ISAs (due to such poor interest rates) using a Stocks and Shares ISA or LISA could generate decent returns. Of course, much will depend on the choice of investments made.

Making the full full ISA allowable contribution each year is a ‘no brainer’ if you can afford to do so. The generous bonus from the government (for a LISA) is like having a guaranteed return but it really is for the long term as the penalty (loss of government bonus plus returns on bonus) could be painful.

Investing into ISAs and LISAs means no tax will be paid on any returns (dividend and interest) received. But unlike saving into a pension arrangement no tax relief on contributions (up to £40,000) a year will be given.

A perfect scenario is to have a pension savings plan in place and taking advantage of as much tax relief as your earnings will allow.

Remember, even if contributions aren’t made every year you can still benefit from ‘carry forward’ if the nature of your self-employment is such that you receive sporadic large payments. Then if you also contribute as much as possible to an ISA you will, hopefully, be setting yourself up for a rosier retirement.

Read More on the Carry Forward and Annual Allowances

Do you like the thought of being able to access your money, if you need to?

If so, an ISA (and not a pension or LISA) could be the most suitable option. The downside is that by having that very flexibility it may prove too much of a temptation NOT to access funds in an ISA! 

As with all financial planning each of our individual circumstances are so different.

IF life is plain sailing with a profitable self employment history then over the course of time sufficient savings into a pension and/or ISA will pay off.

In contrast, if self employment is patchy with wild swings with income sticking to the ISA route may be most suitable.

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