How to use your pension to start a business

For some, the ideal retirement involves long vacations, playing with the grandkids and watching the world go by. But others find that while free time is great, they miss having an occupation and would welcome a bit of extra action. If you are one of the latter, you might have a business idea that you have always wanted to try out and the first few years of retirement can be a good time to do this. One way to fund the business is your pension tax-free lump sum – as long as your retirement income can comfortably take the hit if things go wrong.

Scratching the entrepreneurial itch

Christian Feroze, financial planning director at Investec Wealth, had a client who decided to do just that. An engineer by trade, 'Mr B' had a business idea that did not require a huge amount of capital, and he had the necessary skills and contacts to see it through, so decided to give it a go. Feroze did some robust cash flow planning to make sure that funding the business with Mr B's tax-free pension lump sum was an affordable option even if the business did not take off. Mr B is fairly affluent, owns a mortgage-free home and has substantial income from a defined-benefit pension, as well as a sizable defined-contribution pension pot.

“For him the question was, do I gift the money to my children, have surplus and die with it or pursue this endeavour?” Feroze explains.

Mr B did not have a big enough sum available in his individual savings accounts (Isas) and wanted to avoid the hassle of seed fundraising, so using his pension was the easiest way to fund the business. He did not withdraw the 25 per cent tax-free sum in one go but rather gradually, only crystallising a portion of his pension pot each time. This way, he maintained a degree of flexibility and only took what he needed from his pension. If you crystallise the tax-free portion of your pot but avoid drawing amounts above that, the money purchase annual allowance (MPAA) is not triggered, meaning that you can continue contributing significant amounts to the pot each year.

Mr B’s business is now going well and has a few employees, but for him it was more about “scratching that entrepreneurial itch” rather than making money.

Ian Cook, financial planner at Quilter, says that an increasing number of clients ask about setting up a side business in retirement. This “can often be an emotional reaction to giving up full-time work, and the need for purpose and a place to go each day”, he says. “This can be a nice way for some people to segway into retirement, and often it is less about the income that’s generated but almost always about fulfilling a passion project.” 

Pros and cons of using your pension

The approach chosen by Feroze and Mr B is not suitable for everyone, and has pros and cons. Much depends on how much cash the business requires before it becomes profitable which, depending on the type of business and its scale, might be a much bigger figure than your pensions lump sum. If this is the case, you will have to consider some form of fundraising, even if just from contacts and friends, or a business loan.

Matt Swatton, wealth planning director at Canaccord Genuity Wealth Management, says that one obvious advantage of using your pension is that your business will begin without debt on its balance sheet. But he also points out that taking out a big sum from your pension exacerbates any future losses. If you reduce the value of your pension pot by taking money from it and later on the value of the investments in it fall, “you are going to have to work that much harder to get back what you lost”, he says. You must be prepared to take that risk.

If you have significant investments outside your pension, consider using these – particularly if they are within Isas and can be cashed in tax-free. Investments held outside Isas are subject to capital gains tax (CGT) and the annual allowance for CGT-free gains outside tax-efficient wrappers starts to decrease in April, meaning that cashing in substantial sums could result in a fairly chunky tax bill.

If you have both options, choosing whether to fund a business with your Isa or pension can be a finely balanced choice that depends on which of the two accounts you would rather see reduced. There are a number of considerations, for example a pension is more advantageous from an inheritance tax (IHT) planning perspective, but withdrawals in excess of the tax-free lump sum are subject to income tax, while Isa withdrawals are tax-free.

A good retirement plan?

Starting a business is risky as a high percentage of them tend to fail fairly quickly, so you should not rely on this for the bulk of your retirement income. Initially, a lot of the work is likely to be making sure that the business survives. But as a side hustle – especially when the business becomes profitable – it has various advantages.

“When someone has a small business on the side that we know will generate additional income for a number of years, it can help us to assign other assets in an efficient way, such as using trusts if the cash flow plan we create shows us the capital may no longer be required,” says Cook. “Also, the additional income can mean that we delay taxation from the crystalised portion of the pension, and fewer drawings on tax-free cash, Isas or other cash holdings to provide income in the early and usually more expensive years of retirement.”

You can make pension contributions gross from the turnover of a limited company, reducing the amount of profits on which it pays corporation tax. Pension contributions can be more efficient than paying yourself a salary because the company doesn't pay National Insurance contributions on pension payments. But you need to make sure that you have not triggered the MPAA, which limits pension contributions to £4,000 instead of up to £40,000 a year.

If your spouse is involved in the business they can also receive pension contributions, dividends or a salary from it, which can help to make the most of your combined personal, dividend and pensions lifetime allowances.

Although a business you own will become part of your estate when you die, you can get 100 per cent business relief on IHT if you leave it to your heirs, as long as the business is not an investment company. If you sell your business rather than leave it to your heirs, it might qualify for business asset disposal relief, known as entrepreneurs’ relief prior to 6 April 2020, meaning you only pay CGT at a rate of 10 per cent on the sale profit.

So a business that goes well can be a great financial asset in retirement. “With some good early decisions and tax planning, your side hustle could, for example, end up covering your grandchildren’s school fees,” adds Cook.