Business owners who extract their company’s profits to pay dividends could find freedom in pensions.
Directors of profitable private companies have always been faced with the decision on how best to take profits for their own benefit.
Usually it comes down to finding a tax-efficient blend of salary, bonus and dividends. Many directors prefer to receive a proportion of their pay in the form of a dividend, because it can help to reduce their deductions. Although tax is still payable (albeit at a slightly reduced level), National Insurance contributions (NICs) are not; thus, dividends can often make up the bulk of income drawn from smaller businesses.
After Corporation Tax is paid on company profits, retained profits that are distributed in the form of dividends are taxed at an effective rate of 0% (basic rate), 25% (higher rate), and 30.56% (additional rate). However, from April 2016, dividend payments above £5,000 will be taxed at 7.5% (basic rate), 32.5% (higher rate), and 38.1% (additional rate).
While the new rules will mean a tax cut for some individuals, those whose earnings are slanted towards company dividends could find themselves worse off. Consequently, many directors with cash held in retained profits have recently been bringing forward dividend payments to before 6 April 2016.
Creating a diversion
However, for those who can look beyond immediate income needs, the company’s profits could be made to work much harder in a pension.
“It’s not common knowledge that people who own limited businesses can pay a pension contribution from the business for their own benefit,” says Steve Moy, wealth management consultant at St. James’s Place. Moy argues that, if a business can afford to use some of the profit for the business owner’s personal benefit, then a pension is a perfectly legitimate destination for it. “View the pension contribution as a business expense,” he says.
By moving the cash into a pension, the profits of a company can be reduced, which in turn can lower or eliminate liability to Corporation Tax. Moreover, pension contributions avoid NICs and tax that would be payable on dividends.
Furthermore, freedoms introduced in April 2015 mean that a pension can be drawn flexibly from the age of 55. If you are approaching, or have passed, your 55th birthday, you will be able to take the whole fund back and use the cash as you wish; although this will, of course, be subject to Income Tax.
You can add up to £40,000 to your pension this tax year using pre-tax profits from your business. If you have not made a pension contribution this tax year, or in the previous three, you could use the ‘carry forward’ rule to add up to £180,000 to your pot. By taking it from the business, not only will you have reduced your company’s liability to Corporation Tax, you will have saved Income Tax, including on dividends, and NICs on those contributions.
Contributions of £180,000 made into a personal pension could result in a Corporation Tax saving of £36,000 (assuming a Corporation Tax rate of 20%). But it is important to note that contributions will need to be paid before the company’s financial year-end in order for businesses to qualify for the deduction. In many cases, the deadline will therefore be 31 March 2016.
Please note that the information contained in this article does not constitute investment advice. Full advice should be taken to evaluate risks, consequences and suitability of any prospective investment.
The levels and bases of taxation, and reliefs from taxation, can change at any time and are generally dependent on individual circumstances. The value of an investment with St. James’s Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested.