Pension v dividends – the tricky business of profit extraction

When SME owners come to choose how they take their profits, the argument in favour of pension contributions has been gaining momentum over the last two years.

Changes in how dividends are taxed are encouraging 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 will see higher-rate taxpayers paying £975 more in tax, which makes the pension alternative even more compelling.

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 liability – just like dividends. What’s more, pensions are usually an allowable deduction for corporation tax – like salary.

And of course, under the new pension freedoms, those directors who are aged 55+ will be able to access their funds 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.

One caveat to withdrawing cash (in excess of the 25% tax-free allowance) from the fund is that it will trigger the Money Purchase Annual Allowance (MPAA), which restricts future funding opportunities. HMRC introduced the MPAA to ensure that people cannot ‘recycle’ their pensions by claiming additional relief on any new contributions they make, having just taken their pension benefits.

A quick look at the numbers

In practice, many business owners pay themselves a small salary, typically around £8,000 a year. At this level, no employer or employee NI is due and they will earn credits 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 a higher 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.

  Bonus Dividend Pension
Company profit £40,000 £40,000 £40,000
Corporation tax 19% £0 £7,600 £0
Employer NI £4,850 £0 £0
Value to director £35,150 £32,400 £40,000
Director's NI (£703) £0 £0
Director's income tax (£14,060) (£10,530) £0
Net benefit to director £20,387 £21,870 £40,000

* 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, they almost double the contribution to their pension pot.

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. These values assume pension income is taxed after taking 25% tax-free cash, and there is no Lifetime Allowance charge. Growth has been ignored.

From a family protection point of view, if not withdrawn for income purposes, the full £40,000 could be paid tax-free to the director's dependents should death occur before 75, or otherwise at the beneficiaries’ own marginal rate of income tax.

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, they could 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:

  1. 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
  2. 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 than 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.

Why act now?

With the tax year end approaching, there are several reasons why you may benefit from making an employer pension contribution now:

  • Avoid AA taper – to ensure that this year's annual allowance is not tapered.
  • 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 is taxed.
  • Get in shape for retirement – to maximise tax-efficient funding if you 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

Finally, if your business has a financial year in line with the tax year e.g. it ends on 31st March, you will not be able to confirm any final dividend until after this date. If these dividends are subsequently paid in 2018/19, you may choose to use up next year's lower dividend allowance before the new company year has even started.

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