Trying to extract money from a client’s business sometimes feels like they are being taxed at every turn. Even maximising the available allowances, a combination of Corporation Tax, Income Tax, National Insurance Contributions and Dividend Tax often stand between your client and the money in their company.
Research from the Centre for Policy Studies has estimated that six out of seven higher rate taxpayers are not higher rate taxpayers in retirement. So, could paying into a pension be the best way for a client to extract profits from their business?
The three ways of taking profits from a business
There are three main routes for a business owner to extract profits from their own company:
- Pension contributions (although this is taking money from the company for future use)
The other alternative is to leave the profit in the company and the client takes the proceeds from the subsequent sale.
Let’s look at these in turn.
Clients will be taxed as an employee. In 2020/21 they have a Personal Allowance of £12,500 per annum in 2020/21 (reduced for those with adjusted net income over £100,000) and then the income is taxed at:
- 20% – £0 to £37,500
- 40% – £37,500 to £150,000
- 45% – over £150,000
Note that additional bands and different rates apply in Scotland and Wales.
In terms of employee National Insurance contributions, most employees pay 12% on earnings between £183 and £962 per week, and 2% on earnings above £962 per week.
Dividends are payments from company profits to shareholders and are taxed in the same way as dividends from unit trusts and open-ended investment companies.
In 2020/21, a nil rate of tax applies to the first £2,000 of dividends. Thereafter, dividends are taxed at:
- Basic Rate – 7.5%
- Higher Rate – 32.5%
- Additional Rate – 38.1%
Remember that the 0% is a starting rate of tax on the dividend and not a deduction on the amount of dividend received.
For example, if an individual has fully used their Personal Allowance, is £1,000 below the higher rate threshold and receives £3,000 of dividends, £1,000 of the dividends would be taxable at the higher rate for dividends.
If a client is looking to get the profits out of their business in the most tax-efficient manner, pensions are a great option.
Pensions do not suffer Corporation Tax or National Insurance when these are made from the business and, when the benefits are taken, 25% is usually tax-free and thereafter taxed at marginal rates with no National Insurance to pay.
As we mentioned at the outset, most higher rate taxpayers are not higher rate taxpayers in retirement and so being taxed on income in retirement is likely to result in a lower tax bill.
Any unused profit left after satisfying a client’s immediate income need and not needed by the business, could therefore be used to make pension contributions.
As, unlike individual contributions, employer pension contributions are paid before the deduction of both National Insurance contributions and Corporation Tax, 100% of the profit is available to the business owner in the future. This is usually only subject to marginal rate Income Tax on 75% of the pension fund.
This gives effective tax rates of 0%, 15%, 30% and 33.75%, depending on the client’s tax status in retirement. Given all the taxes for the company and the individual, these are likely to be lower.
Taxation on death
Another tax benefit of saving into a pension is that they are usually free of Inheritance Tax on death.
If a client dies before the age of 75, pension benefits are free of tax when these are paid to an individual. After the age of 75, death benefits are taxed at the individual beneficiary’s marginal rates of taxation.
Additionally, where the business owner dies when the business still has value, there is relief available for certain types of business or business property included in either a lifetime transfer or the deceased’s death estate.
This may be 100% or 50% relief, depending on the nature of the company. See our longer guide to Business Property Relief for more information.
Get in touch
As we have seen, there are a limited amount of options for extracting company profits. Each of these has its own particular tax and National Insurance consequence for the business owner, and each client will be different.
In simple terms, your client might want to extract the minimum amount of profit required to fill their bank account for immediate needs with the rest going into their pension to maximise their bank account of the future.
We’re here to advise you and your clients on all aspects of financial planning. If you have clients that would benefit from advice, or you’re interested in how you can work more closely with us, please get in touch. Email firstname.lastname@example.org or call 01454 416 653.