When the owners of SME companies choose how they take their profits, the argument in favour of pension contributions has been gaining momentum over the last 2 years.
While dividends may still be king, changes in how they are taxed are driving more directors who don't need the income for day to day living to extract profits using employer pension contributions instead. The impending 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 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 there's no employer or employee NI to pay, like dividends. But it's usually an allowable deduction for corporation tax, like salary.
And of course, under the new pension freedoms, those 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 (but remember, the MPAA will be triggered, restricting future funding levels).
In reality, many business owners will pay themselves a small salary, typically around £8,000 a year – at this level, no employer or employee NI is due and credits will be earned towards the State pension. 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?
The table below compares the net benefit ultimately derived from £40,000 of gross profits to a higher rate taxpaying shareholding director this year.
Ian Lawrence www.lawrencerose.co.uk
Corporation tax 19%
Value to director
Director's income tax
Net benefit to director
* Assumes full £5,000 annual dividend allowance has already been used .
Clearly, the dividend route provides more spendable income than the bonus alternative, but 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.
Tapered Annual Allowance
Many high earning business owners could see their annual allowance (AA) tapered down to just £10,000. However, by reducing what they take in salary or dividends and paying themselves a larger 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 'threshold income'.
For example - Amy, 55, runs her own company and pays herself dividends of £150,000 for the 2017/18 tax year. She has no other income. She makes employer contributions of £20,000 into her SIPP.
The two tests which determine whether the AA is tapered are:
Adjusted income – if this is more than £150,000 the AA is reduced by £1 for every £2 over the limit, subject to a minimum allowance of £10,000
Threshold income – if this is less than £110,000, there will be no tapering and the full £40,000 allowance will be available.
Her 'adjusted income' is £170,000 (income + employer pension contribution). As this is £20,000 above the £150,000 cap, it would normally cut her AA by £10,000 (to £30,000). This means any opportunity to increase her funding for this year, or in the future using carry forward from 2016/17, would be limited to £10,000.
However, if she cuts her dividends by just over £40,000 her 'threshold income' (total income without employer contributions) would be below £110,000, preserving her full £40,000 allowance.
She could pay the corresponding amount (which would actually be £49,383 - more than the £40,000 dividend which is net of corporation tax) into her pension as an employer contribution using carry forward of unused AA from previous tax years. This would not affect her AA for 2017/18 because only employer contributions as part of new salary sacrifice arrangement are used to determine threshold income. A shareholder director making an employer pension contribution rather paying salary or dividend is not salary sacrifice.
As Amy is over 55, she has unrestricted access to the funds in her SIPP. If she made use of the new income flexibilities she would trigger the money purchase annual allowance (MPAA) cutting her future funding to £4,000 a year, with no opportunity to use carry forward. However, if she only touches her tax free cash and takes no income she would retain her full AA.
With the tax year end approaching, there are several reasons why your clients may benefit from making an employer pension contribution now:
Avoid AA taper - 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 2014/15 which would otherwise be lost.
Deliver more tax efficient income - so that profits which may otherwise be taken as bonus or dividend do not boost income to the point where the personal allowance is lost, or child benefit taxed.
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 31st March. These companies will not be able to confirm any final dividend until after this date. If these dividends are subsequently paid in 2018/19, they may use up next year's lower dividend allowance before the new company year has even started.