Running your own business is rewarding in lots of ways. However, while being your own boss and steering the direction of your company is hugely exciting, getting the financial and legal aspects right can be more of a challenge.
A question that we get asked regularly is: “Is it better for a company director to take dividends and make a personal pension contribution, or make pension contributions from the company?”
Read on to look at the pros and cons of each strategy, and for a couple of case studies that illustrate the issues.
Company vs private pension contributions
If a client is the director of their own business, they have two broad choices for how their pension contributions are made:
- By taking a salary and/or dividends and making personal pension contributions
- The company makes the contributions on their behalf
Paying into a pension from personal income enables an individual to receive tax relief based on the rate of income tax they pay. So, for example, if they are taxed at the basic rate of 20%, for every £80 they put into your pension, they will receive £20 tax relief and £100 will be invested.
While there is currently no limit as to how much an individual can pay into a personal pension, the amount they can invest and still claim tax relief on is restricted to 100% of their earned income, up to £40,000 a year.
As a director of a limited company, a client is likely to take a low salary from their business and supplement their income through dividends from company profits.
One issue with this is that HMRC does not consider dividends to be ‘relevant UK earnings’. This means that tax relief will be limited to their salary.
So, if an owner-manager takes only a minimal salary and the rest of their income as dividends, a personal contribution is likely to be restricted as the investment they want to make will exceed their ‘salary’.
The alternative is to take any excess income from the limited company and pay it into a pension.
Pension contributions made through the company are not subject to:
- National Insurance
- Corporation Tax
Employer pension contributions paid through a limited company are considered allowable business expenses. This means that the company will be granted Corporation Tax relief (at the current rate of 19%) on money paid into a pension pot. It will essentially cost the business £81 for every £100 paid into a pension scheme.
Paying employer pension contributions through the limited company also means that a client does not pay National Insurance on them.
It is worth remembering that HMRC states that pension contributions must be ‘wholly and exclusively’ for the purposes of the trade for them to be deductible.
For example, HRMC could ask for evidence to check whether someone else in the company is benefiting from this arrangement, e.g. a spouse who is ‘employed’ but rarely visits the premises and undertakes very little work.
Consider the annual and lifetime allowance
Making a contribution from the business will also allow an individual to pay as much as they like into their pension, and the contributions will be tax-free, providing they do not exceed the annual allowance (currently £40,000 per year).
Any contribution should come from the company’s trading. If an individual pays more into their pension than the company’s income, HMRC may well start looking into where this money has come from.
If a client wants to pay a large sum of over £40,000 into their pension pot, they may be able to use the ‘carry forward’ rule as long as:
- They have not used the annual allowance in the previous three years
- They use the annual allowance from the current tax year
- They have been part of a registered pension scheme for at least three years
The other limit to consider is the lifetime allowance (currently £1,055,000). This is the limit on the amount that can be withdrawn from a pension pot without incurring any extra tax charges.
Case study 1 – Post-tax profits are in the higher rate band, but the client’s total income is under £100,000
Personal pension contribution
If the client makes a personal pension contribution, the pension fund gets the benefit of the 20% ‘top up’ from the government. The individual also gets an extension to the basic rate band, meaning that more dividends are taxed at 7.5% rather than 32.5%.
Company pension contribution
If the client decides to forego some of the dividend and the company makes the contribution on the client’s behalf, the company saves corporation tax at 19%. There is also an Income Tax saving through not taking the post Corporation Tax dividend in the higher rate band.
Case study 2 – Post-tax profits are in the additional rate band (more than £150,000)
Personal pension contribution
If the client makes a personal contribution, then the pension benefits from the 20% ‘top up’ and the individual gets an extended basic rate band, meaning more dividends are taxed at 7.5% rather than 38.1%.
If the client decides to forego some of the dividend and the company makes the contribution, then it saves Corporation Tax at 19% and there is an income tax saving of not taking the post corporation tax dividend in the higher rate band.
Get in touch
Each client is different and the most appropriate way to make pension contributions will be determined by their specific circumstances.
We can advise clients on the best options for them. 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.