Profit Extraction and Company Pension Contributions
Following on from our blog on Salary vs Dividends, we thought we would take a detailed look at another form of extracting profits from a company; employer pension contributions.
Once you become a higher rate taxpayer, effective rates of tax on extracting company profits into your personal name are high. This intensifies once personal income exceeds £100k and the personal allowance is clawed back, with additional rate tax then kicking in at c. £125k.
Employer pension contributions can offer the opportunity of withdrawing profits into your personal name in a far more tax efficient way. An example scenario is shown further down.
Pension Tax Basics
Contributions
A qualifying employer pension contribution is Corporation Tax deductible. To be qualifying it must be for wholly for the purpose of the company’s trade i.e. must be justifiable as part of the business owner’s remuneration. This isn’t usually an issue for a business owner-director.
An employer pension contribution is tax free in the hands of the individual – it’s not a Benefit in Kind and not subject to income tax or national insurance contributions (NICs).
A qualifying employer contribution can therefore pass profits directly into your pension, with no tax deducted.
Growth
Pensions grow free of UK income and capital gains taxes. For example, interest on cash, dividends on company shares or rent on commercial property are free of income tax. You cannot hold residential property in a pension!
Withdrawals
Currently, 25% of pension funds can be drawn as a tax-free lump sum. On this amount, company profits have passed tax-free into a pension, they’ve grown tax free and been paid to you tax free.
The remaining 75% of pension benefits must provide a taxable income. On this amount, income tax has been deferred rather than avoided (although no NICs have been paid).
Pensions are typically drawn in retirement once earned income has reduced or ceased. Consequently, the tax paid on pension income can often be at a lower rate than avoided at outset by making the contribution.
Access
Pensions are designed to be used to fund retirement and consequently you cannot access and spend your pensions in the short-term, in the same way you can a bonus or dividend paid straight into your bank account.
Currently you cannot access your pension until age 55. This will rise to age 57 in 2028 (and remain 10 years below the state pension age – which will increase).
The younger you are, the more conservative you will likely need to be in making large contributions, ensuring you have sufficient short- and medium-term assets accessible. For those in their 50’s and above, this will be less of a concern.
Contribution Limits
For personal contributions, you can only contribute up to 100% of your earnings (excludes dividends) and still receive tax relief. This is not the case with employer contributions.
There is still the Annual Allowance which limits all pension contributions* to £60,000 per tax year. This limit is reduced if your total income (from all sources) PLUS employer pension contributions exceeds £260,000.
* including benefit accrual in salary-related schemes e.g. final salary pensions.
Death Benefits / Estate Planning
Assets in pensions can be passed on in the event of your death free of Inheritance Tax (IHT)*.
On death before age 75, pensions can pass 100% free of any tax to your chosen beneficiaries. It’s also possible to pass pension death benefits into a trust, to prevent the funds from entering any individual’s estate.
On death after age 75, pension death benefits are subject to income tax in the hands of the recipient, in a similar way that pension income drawn by the owner in retirement is subject to income tax.
* provided distributed within 2 years of death
Profit Extraction Scenarios
If we imagine a business owner-director whose company makes an operating profit of £185,000 (before their remuneration) and they drew all the profit (mainly as dividends), the tax position would look as follows:
We assume no other income for the business owner’s individual position.
If the business owner chose to make a £60,000 employer pension contribution, then (assuming the contribution is a qualifying expense) the position would be as follows:
Important note: the above tables consider the three listed taxes only and is based on drawing current year trading profits. It doesn’t consider any other sources of personal income and doesn’t include the potential loss of any benefits as a result of increased income.
The pension contribution reduces taxable profits, Corporation Tax and the individual’s earnings. As their earnings are now below £100k they regain their full personal allowance, reducing taxable income further.
By making the £60,000 employer contribution their net pay only falls by £23,990. The remaining c. £36k (60%) has been funded by reduced tax bills.
When the business owner draws those pension benefits they will pay some income tax, but there is a good chance it won’t be anywhere near £36k. They could take 25% (£15k) as a tax-free lump sum and draw the remaining 75% (£45k) subject to income tax. If taxable income was taken post-retirement, this might only be at the basic rate (20%).
Of course, we are only considering a single business owner with the above example. A couple owning a business would have even greater scope for extracting profits efficiently.
Speak to us
Pension contributions can be a very powerful tool in efficient profit extraction and remuneration planning. They can also help fulfil retirement planning / financial independence objectives and/or contribute towards estate planning aims at the same time.
If you need any help with extracting profits from your business or planning your pension contributions, do please get in touch and we can see if we can help.
If you would like more detailed information on contributing to pensions, please see our Business Owner’s Guide to Pension Funding.
Disclaimer
The above is provided for general information only. No action should be taken without seeking advice for your specific circumstances. Collingbourne Wealth Management does not provide tax advice. All information is based on our understanding of current tax rules as at the time of writing, which can is subject to change.
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