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Some self-employed clients may get an unexpected opportunity to boost their pension funding from April. Self-employed profits are to become aligned with the tax year from April 2024. This could result in some clients having much higher than anticipated pensionable income in the transitional year 2023/24.

According to the Office of National Statistics (ONS), only 20%* of self-employed individuals were contributing to a pension between 2018 and 2020. So these inflated earnings may present an opportunity for some clients to make up for gaps in their pension funding and counter higher tax bills, potentially using carry forward of any unused annual allowance from earlier years. And the good news is that these additional earnings will not count towards the thresholds for the tapered annual allowance.

It should be noted that clients who already have an accounting period aligned to the tax year will not be affected by these changes.

What's changing?

From 6 April 2024 self-employed profits will be taxed in the tax year in which they arise. Currently, clients who are self-employed or are in a partnership will be taxed on profits made in the accounting period ending in the tax year. A business that has a 12 month accounting period ending on the 30 April each year will be taxed in the 2022/23 tax year on the profits in the year ending 30 April 2022.

Choosing a date that ends early in the tax year is popular as ultimately it allows businesses a longer period before the tax bill has to be settled. So the tax on profits for the business year ending 30 April 2022 does not have to be settled until 31 January 2024. From a pension perspective, it also means that profits are known well in advance of the tax year end and therefore easier to gauge the level of contribution.

This means that where the accounting period is not re-aligned to the tax year and the business year end is unchanged, profits will be proportionately applied to the tax year in which they accrued. For example, if Tony's accounting period runs from 1 June – 31 May each year his tax bill for the 2024/25 tax year will be based on:

• 2/12ths of the profits from the accounting period ending 31 May 2024, and
• 10/12ths of the profits from the accounting period ending 31 May 2025

As a consequence UK relevant earnings for pension purposes may not be known until after the tax year end and pension contributions based on estimated profits.

The transitional year 2023/24

Self-employed individuals will be taxed on the profits for the accounting period ending in that tax year in the normal way but, in addition to this, they will also pay tax on the balance of profits accruing up to the 5 April 2024.

So if we take the example of Tony above, for 2023/24 he will be assessed on 22 months profits in the tax year. The full year for the accounting period ending May 2023 plus the 10 months to the 5 April 2024.

HMRC have recognised the extra tax burden that could be placed on the self-employed in 2023/24 and there are transitional provisions which offer some relief. Although the impact on pensions funding is not at the core of these provisions, they may nonetheless have benefits for pension savers.

The 'transitional' part of profits (i.e. profit arising between the end of the accounting period and 5 April 2024), which would otherwise be taxable in 2023/24, can be spread over a maximum of five tax years (starting with 2023/24) to prevent, in some cases, almost two years' worth of profits being taxed in the same tax year.

In addition, any overlap profits arising from the initial years of trading, normally used when an individual ceases to be self-employed, must be deducted from profits in the transitional year.

What it means for pension funding

Transitional profits will boost UK relevant earnings in the year/years they are assessed to tax.

This might be good news for those looking to maximise pension funding. An earnings spike might be an opportunity to make a larger pension contribution using carry-forward of unused annual allowance. Unlike business owners, who can make employer pension contributions, the self-employed are only able to make personal contributions which will be limited by their UK relevant earnings.

However, the extra transitional profit, whenever assessed, will not be included in adjusted income (or threshold income) calculations and so will not exacerbate any tapering of the annual allowance. This is a by-product of legislation included to ensure that such profits won't unfairly result in the loss of personal allowance or child benefit.

With UK relevant earnings up, and with no additional impact on the annual allowance, there may even be an opportunity for some to pay a larger contribution which could actually reverse any existing tapering of the annual allowance by reducing threshold income to below £200,000.

The slashing of the additional rate threshold from £150,000 to £125,140 from April may prove another motive for some to maximise pension contributions next year. This cut could cost clients up to an extra £1,243 in income tax.

A self-employed client with total taxable profits of £150,000 in 2023/24 making a contribution of £50,000 would receive tax relief at 45% on £24,860 and 60% on £25,140 (40% tax relief plus a further 20% by reinstating their personal allowance).

Summary

It's particularly important to ensure self-employed clients are able to maximise their pension funding as they typically have no employer contributions to fall back on. While it will be business as usual for pension funding for the many self-employed clients whose accounts are aligned with the tax year, it's easy for those clients who are affected to miss a funding opportunity.

* Saving for retirement in Great Britain - Office for National Statistics (ons.gov.uk)