You or the Company?
Maximise your tax-free pension savings
PROBABLY the most common tax planning question asked by company owners is: “How can I get money out of my company without paying too much tax?”
The recommended ‘bread and butter’ tax planning advice for most company owners is to take a small salary – which is tax deductible for the company but tax-free for the director – and a dividend equivalent to the basic-rate band free of income tax.
For the current 2011/12 tax year, the optimal salary for most directors of companies with profits under £300,000 is £7,225. This amount will be free of income tax and employee’s national insurance. There will be a small amount of employer’s national insurance (which kicks in on salaries over £7,075), but this will be more than compensated for by the additional corporation tax relief.
In addition to a £7,225 salary, the director can then take a cash dividend of £31,725 (£35,250 gross dividend) with no additional income tax arising.
Total income free of personal taxes: £38,950. If the company is owned and operated by a couple, this tax-free amount doubles up to £77,900.
But what if you want to extract more money from your company and minimising tax remains a priority?
One of the most tax-efficient things you can do is make a pension contribution. A pension contribution is a bit like additional tax-free salary, only you can’t get your hands on the money immediately.
The critical question many company owners ask is: “Should I make the pension contribution personally or get my company to make it for me?”
The short answer is this: If you want to make a relatively small pension contribution (no more than your small tax-free company salary) you should probably make the contribution personally. Additional contributions should be made by your company.
Why? Company directors who make contributions personally can enjoy up to 42.5% tax relief (providing they are higher-rate taxpayers and have dividend income). Company pension contributions effectively provide 40% tax relief – not bad, but not quite as much.
Let’s now examine some of the issues with the help of a detailed example.
Lisa owns Springfield Ltd. She takes tax-free income of £38,950 (as described above) but still has £10,000 of after-tax profits sitting in the company.
She can do the following with the £10,000 of spare cash:
- Leave the money in the company
- Pay a taxable dividend
- Pay a dividend and make a pension contribution
- Make a company pension contribution
Leaving money in the company
Leaving the money in the company may be the best solution if Lisa intends to reinvest it in the business or withdraw it, possibly tax free if she is a basic-rate taxpayer in a future tax year.
Lisa has already utilised her income tax personal allowance and basic-rate band for the current tax year. If she takes the remaining £10,000 as a dividend she will pay 25% income tax (£2,500), leaving her with total income of £46,450 net of all taxes.
Dividend and Pension Contribution
If Lisa takes a £10,000 dividend she could invest some, but not all, of the money in a personal pension. Remember, pension contributions in excess of £3,600 (£2,880 net) cannot exceed your earnings. Salaries are earnings, dividends are not.
Because her salary is £7,225, the maximum gross pension contribution she can make is £7,225. Lisa will invest £5,780 of her own cash (£7,225 x 80%) and the taxman will add £1,445 in basic-rate tax relief to her pension plan for a total gross contribution of £7,225. When Lisa submits her tax return, she will also receive £1,626 of higher-rate tax relief:
£7,225 x 22.5% = £1,626
(See the accompanying Pension Tax Relief & Dividends box for an explanation.)
In total, Lisa will save £3,071 in tax by making a pension contribution: 42.5% of her £7,225 gross contribution. Most higher-rate taxpayers only enjoy 40% tax relief on their pension contributions, so this is an attractive outcome.
The downside of making pension contributions to save tax is that £7,225 of Lisa’s money is now locked away until she reaches age 55 and, even then, she can only tap it gradually. Her after-tax disposable income has fallen from £46,450 to £42,296, so although Lisa is better off overall, she has less money to spend during the current tax year.
Company Pension Contribution
Instead of Lisa making the pension contributions personally, the company could make the contributions. The size of company contributions is not restricted to the level of an employee’s earnings. However, for comparison purposes, we will assume that Springfield Ltd also makes a £7,225 pension contribution.
Lisa will not obtain any tax relief personally but Springfield Ltd will claim the amount as a corporation tax deduction. To understand how a company pension contribution will affect Lisa’s financial position, we take Lisa Ltd’s £10,000 of after-tax profits, add back the 20% corporation tax and go from there:
Less: Pension contribution £7,225
Taxable profits £5,275
Corporation tax @ 20% £1,055
After-tax profits/cash dividend £4,220
Income tax @ 25% £1,055
After-tax dividend £3,165
Total after-tax income: £38,950 tax-free + £3,165 after tax = £42,115
As before, Lisa has £7,225 sitting in her pension pot but her after-tax disposable income has fallen from £42,296 to £42,115: the company contribution is not as tax efficient as the contribution made personally.
This is because company pension contributions effectively produce 40% tax relief, rather than the 42.5% which Lisa enjoyed on her personal contribution.
How do we get to 40% relief for the company contribution? If Lisa extracted £7,225 of after-tax profits as a dividend instead, there would be £1,445 more corporation tax and £1,445 more income tax. The total extra tax would be £2,890: 40% of £7,225.
Additional Pension Contributions
If Lisa wants to make an additional pension contribution in excess of her £7,225 salary earnings, she has two choices:
- Pay herself more salary (more earnings) and make the contribution personally
- Get the company to make the additional contribution
Paying more salary is probably a bad idea because the additional salary will attract 12% employee’s national insurance and 13.8% employer’s national insurance. None of this national insurance can be avoided because pension contributions only attract income tax relief.
The solution therefore is to get the company to make the additional contribution.
Company Pension Contributions
The important thing to note about company pension contributions is you do not need a dedicated company pension scheme to make them. Most providers of personal pensions, like SIPPs, have special forms that allow your company to pay directly into them.
How much can the company contribute?
The company’s contributions are not limited to your salary earnings, but it is important to remember the new Annual Allowance that applies from 6th April 2011: The maximum total gross pension contributions that can be made by both you and your company may be limited to £50,000 per year.
Furthermore, HM Revenue & Customs has issued instructions to its tax offices to be on the look-out for corporation tax relief claims for ‘excessive’ pension contributions. Your total remuneration package, including salary, pension contributions and other benefits in kind, must be commercially justifiable.
Relevant factors would include:
- The number of hours you work, your experience and your level of responsibility in the company.
- The pay of other similar employees in your company and other companies.
- The pay required to recruit someone to take over your duties.
- The company’s financial performance.
Extra care may be necessary in the event of a large one-off company pension contribution. It may be sensible to document the commercial justification (e.g. strong recent financial performance of the company) in the minutes of a directors’ board meeting and hold a shareholders’ meeting to approve the contribution.
Having said all this, the good news is that if, like Lisa, you only pay yourself a small salary, and take the rest of your income as dividends, you will often still have plenty of commercial justification to pay yourself further remuneration in the form of company pension contributions.
Pension Tax Relief & Dividends
Higher-rate taxpayers pay income tax at an effective rate of 25% on their cash dividends (net dividends). This is a useful shortcut calculation but most tax return computations work with gross dividends.
Gross dividends are simply cash dividends divided by 0.9. There is effectively no income tax on gross dividends that fall within the £35,000 basic-rate band. Beyond that, the effective income tax rate on gross dividends is 22.5% (32.5% minus a 10% dividend tax credit). It’s odd and overly complex, but that’s tax law for you.
If you make pension contributions, the taxman lets you have more tax-free dividend income. This is achieved by increasing your tax-free basic-rate band by your gross pension contributions.
This means the tax saving on your pension contributions (higher-rate tax relief) is your gross pension contribution multiplied by 22.5%.
Lisa invests £5,780 of her cash dividends (£6,422 gross) in her personal pension. The taxman adds £1,445 of basic-rate tax relief, so her gross pension contribution is £7,225.
Her basic-rate band is increased by £7,225, which means £7,225 more of her gross dividends are effectively tax free (even though she only invested £6,422 of her gross dividends in her pension). Her higher-rate tax relief is:
£7,225 x 22.5% = £1,626
Combined with the £1,445 basic rate relief given at source, this produces the total effective relief of 42.5% which is available to many company directors (£1,445 plus £1,626, divided by £7,225).Note, Lisa will only enjoy 42.5% tax relief if she has at least £7,225 of gross dividends taxed at 22.5%, i.e. more than she actually invested in her pension plan.