Employer Pension

Ensure you and your employees are making full use of the benefits available.

While dividends may still be king, changes in how they are taxed are driving more directors who do not need the income for day-to-day living, to extract profits using employer pension contributions. The recent drop in the annual dividend allowance from £5,000 to just £2,000 from April 2018 means that higher-rate taxpayers could face a further tax bill of £975, increasing the focus on the pension alternative.

Tax Efficient Profit Extraction

Despite the dividend option becoming more expensive, it still remains a better option than salary for most directors withdrawing profits significantly above 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 the most tax efficient way of extracting profits from a business. An employer pension contribution means that there’s no employer or employee NI liability – just like dividends. But, it’s usually an allowable deduction for corporation tax – like salary.

Under the new pension freedoms, directors who are over 55 will be able to access it as easily as salary or dividend. With 25% of the pension fund available tax-free, it can be very tax efficient, especially if the income from the balance can be taken within the basic rate.

In reality, many business owners will pay themselves a small salary. They will then take the rest of their annual income needs in the form of dividend, as this route is more tax efficient than taking more salary. But what about the profits they have earned in excess of their day-to-day living needs?

Clearly, the dividend route provides more spendable income than the bonus alternative, however, if the director does not need this income, the value in their pension pot is almost doubled.

When they take money from their pension to support their income needs, the figures still compare favourably. Assuming the £40,000 fund is taken when the director is a basic rate taxpayer, net spendable income will be £34,000*. If taken as a higher-rate taxpayer, net spendable income will be £28,000*. That is 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From a family protection point of view, if not withdrawn for income purposes, the full £40,000 could be paid to the director’s loved ones tax-free should death occur before 75 or otherwise at the beneficiaries own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 there is no Lifetime Allowance charge. Growth has been ignored.

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