Techzone

When owners of SME companies choose how to take their profits, there’s a strong argument in favour of pension contributions.

While dividends may still be king, changes in how they are taxed may drive more directors who don't need the income for day to day living to extract profits using employer pension contributions instead. Remember, since April 2018, the dividend allowance is just £2,000.

Tax efficient extraction

Taking profits as salary is more expensive than taking it as a dividend, even with the reduction in the annual dividend allowance. For a higher rate taxpayer, the combined effect of corporation tax at 19% and dividend tax of 32.5% will still yield a better outcome than paying it out as salary, which needs to account for income tax at 40% plus employer NI of 13.8% and employee NI of 2%.

However, a pension contribution remains even more tax efficient. An employer pension contribution means there's no employer or employee NI liability - just like dividends. But it's usually an allowable deduction for corporation tax - like salary.

And of course, with modern flexible pensions, directors over 55 can access it as easily as salary or dividends. With 25% of the pension pot normally available tax free, it can be very tax efficient - especially if the income from the balance can be taken within the basic rate. But remember that taking drawdown income will trigger the MPAA, restricting future saving options.

In reality, many business owners may pay themselves a small salary, typically around £8,000 a year – building-up State pension entitlement without triggering NI. They may then take the rest of their annual income in the form of dividends, as this route is more tax efficient than taking more salary. But what about profits they don’t need in excess of their day to day living needs?

The table below compares the net benefit ultimately derived from £40,000 of gross profits to a higher rate taxpaying shareholding director in the 2018/19 tax year.

* Assumes full £2,000 annual dividend allowance has already been used.

Clearly, the dividend route provides more spendable income than the bonus alternative. But if the director doesn’t need this income, the value in their pension pot is almost doubled.

When the client takes money from their pension, the figures still compare favourably. If the £40,000 fund is taken when the director is a basic rate taxpayer, net spendable income will be £34,000** (or £28,000** if taken as a higher rate taxpayer). That is respectively 55% and 28% more than the dividend option.

From a family protection point of view, if not withdrawn for income purposes, the full £40,000 could be paid to the director's loved ones tax free should death occur before 75, or otherwise at the beneficiaries’ own marginal rate of income tax.

** Assumes pension income is taxed after taking 25% tax free cash, and that there’s no Lifetime Allowance charge. Growth has been ignored. Based on main UK tax rates and allowances: not Scotland.

Tapered Annual Allowance

Many high earning business owners could see their annual allowance (AA) tapered down to just £10,000. However, reducing what they take in salary or dividends and paying themselves a larger employer pension contribution instead could mean they retain their full £40,000 AA. This is because contributions of this type should not be viewed as salary sacrifice, and therefore will not count towards their 'threshold income'.

Why now?

With the tax year end approaching, there are several reasons why your clients may benefit from making an employer pension contribution now:

• Avoid AA tapering - to ensure that this year's annual allowance is not tapered. Remember bonus and dividends count towards the £110,000 threshold income, but employer contributions normally don't.
• Use full pension allowance - to use up any unused annual allowance from 2015/16, which could be more than you think and would otherwise be lost.
• Deliver more tax efficient income - so that profits which may otherwise be taken as bonus or dividend don’t boost income to the point where the personal allowance is lost, or child benefit tax charge is applied.
• Create a tax efficient legacy – pensions typically don’t form part of the estate for IHT.
• Get in shape for retirement - to maximise tax efficient funding if they shortly plan to reduce working hours pre-retirement and start to draw pension income, at which point any future funding will be restricted to the money purchase annual allowance of £4,000 and unused carry forward allowances lost.

In addition to this, there will be many companies with a financial year in line with the tax year, e.g. where the company business year ends on 31 March. These companies will not be able to confirm any final dividend until after this date. If these dividends are subsequently paid in 2019/20, they may use up next year's dividend allowance before the new company year has even started.