Company vs personal pension contributions for owner-managers

Company vs personal pension contributions for owner-managers

Company vs personal pension contributions for owner-managers

A common scenario we get asked to advise on is whether it is more tax efficient for a sole director-shareholder of a profitable company to have their intended pension contribution paid by the company or whether they should take dividends and make a personal contribution. This article shows that there is no exact rule of thumb and therefore the question must be answered on a case by case basis.

There are a number of questions which first must be given consideration including:-

  1. Does the taxpayer have sufficient ‘relevant earnings’ to validate tax relief on personal pension contributions?
    ‘Relevant earnings’ do not include dividend income so if an owner manager takes only a minimal salary and the rest of their income as dividends then a company contribution is likely to be required if the amount to be invested into the pension fund exceeds their salary amount.
  1. Will the contributions be within the taxpayer’s annual allowance of £40,000 per annum, which is combined limit for employer and employee contributions?
    There is the option to carry forward unused contributions from the previous three tax years, however there is also an abatement of the allowance for tax years since 2016-17 where the taxpayer has net income above £150,000.
  1. Has the taxpayer taken financial advice to establish that additional contributions into their pension fund are likely to be needed to meet their expected retirement income requirements?
    This article covers some of the tax considerations but advice from an independent financial advisor should be sought before taking any action.
  1. Will declaring dividends to fund a personal contribution push the taxpayer into an income ‘bracket’ which the extending of the basic rate band will not offset?
    For example, the band of income between £50,000 and £60,000 where a higher earner in a household has to repay child benefit payments.

We have performed some calculations to see how the overall rates of tax relief compare between company and personal pension contributions for an owner-manager across different income bands.

We have assumed the owner manager takes a salary equal to the personal allowance plus the basic rate band each year (salary of £45,000 for 2017-18) and pays all post corporation tax profits out in dividends. The calculations ignore the impact of the £5,000 dividend nil rate band (set to reduced to £2,000 in 2018-19),

Our tax relief figures are shown as a percentage of the money added to the pension fund, taking into account any income or company tax savings plus any tax reclaimed by the pension provider.

Tax relief on personal contributions

As well as the pension fund claiming back the basic rate tax paid on personal pension contributions (at 20%), the taxpayer receives further tax relief via the extension of his or her basic rate tax band. In our examples this means the owner receives tax relief of a further 25% (i.e. 32.5% less 7.5%) if they are in the higher rate band, or 30.6% (38.1% less 7.5%) as an additional rate taxpayer.

Tax relief on company contributions

To calculate the tax relief on company contributions we need to take into account both the corporation tax saved (at the current rate of 19%) and also any personal tax that would have been charged on the dividends foregone. There are three main dividend tax rates (i.e. 7.5%, 32.5% or 38.1%) for varying levels of income.

Illustration 1 – post-tax profits within higher rate band but total taxpayer income would be <£100k

If the taxpayer makes a personal pension contribution then the pension fund gets the benefit of the 20% ‘top up’ from the Government, and the individual gets an extension to the basic rate band, meaning that more dividends are taxed at 7.5% rather than 32.5%. This gives an overall rate of tax relief of 45%.

If, instead, the taxpayer agrees to forego some of the dividend and the company makes the contribution on the taxpayer’s behalf then the company saves corporation tax at 19% and there is an income tax saving of not taking the post corporation tax dividend in the higher rate band which would have meant an income tax charge of 32.5% x 81% = 26.3%, therefore an overall rate of relief on the contribution of 45.3%. There is a marginal tax saving of 0.3% of having a company pension contribution within this band of income.

Illustration 2 – post-tax profits within higher rate band and total taxpayer income would be between £100k and £123k

Between £100,000 and £123,000 of income a taxpayer’s entitlement to the personal allowance of £11,500 for the current tax year is abated by £1 for every £2 of income. The net effect is that the marginal rate of income tax is normally around 20% higher within that income bracket.

If the taxpayer makes a personal contribution then the pension benefits from the 20% ‘top up’ and the individual gets an extension to their basic rate band, meaning that more dividends are taxed at 7.5% rather than 52.5%. This gives an overall rate of tax relief of 65%.

If, instead, the taxpayer foregoes some dividends and the company makes the contribution then it saves corporation tax at 19% and there is also an income tax saving of not taking the post corporation tax dividend in the higher rate band (of 52.5% x 81% = 42.5%), therefore an overall rate of relief on the contribution of 61.5%. There is a marginal tax saving of 3.5% of having a personal pension contribution within this band of income.

Illustration 3 – post-tax profits within higher rate band and total taxpayer income would be >£123k

This band is the same as Illustration 1 above – a 0.3% saving of having a company pension contribution.

Illustration 4 – post-tax profits within additional rate band (i.e. greater than £150k)

If the taxpayer makes a personal contribution then the pension benefits from the 20% ‘top up’ and the individual gets an extended basic rate band, meaning more dividends are taxed at 7.5% rather than 38.1%. This gives an overall rate of tax relief of 50.6%.

If, instead, the taxpayer foregoes some dividends and the company makes the contribution then it saves corporation tax at 19% and there is an income tax saving of not taking the post corporation tax dividend in the higher rate band (of 38.1% x 81% = 30.9%), therefore an overall rate of relief on the contribution of 49.9%. There is a marginal tax saving of 0.7% of having a personal pension contribution within this band of income.

Summary

Clearly there is no prevailing rule of thumb as to whether a company or personal pension contribution will be better. It is clear that the answer depends on the band of income; however a taxpayer with an alternative income mix may have different overall tax relief rates to those shown above. If you have any queries or would like our assistance then please contact us.

This is intended as a summary and overview of the tax situation and does not constitute financial advice and no action should be taken without first seeking professional advice specific to your circumstances.

James Boustead

Tax Manager

Matt Clarke

Tax Senior
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