Those in control of how to extract money from their business broadly have three main options. These are to take out the money either as salary, dividends or by making employer pension contributions.
The Health and Social Care Levy and the increase in dividend tax rates both make the extraction of profits via pension contributions more attractive. To provide a shareholding director with their immediate income needs the company accountant will often suggest paying a minimal salary, perhaps up to the secondary earnings limit (£170 pw in 2021/22). They will usually take the rest in dividends. This is unlikely to change but after immediate income needs have been met, pension contributions should be considered.
Any further dividend payments will be subject to both corporation tax and the higher dividend tax rates (assuming the tax-free dividend allowance has already been used up) of 8.75%, 33.75% and 39.35%. In contrast, a pension contribution will not be subject to immediate tax, and, providing it meets the usual “wholly and exclusively” rules, will be treated as a business expense. There will, of course, be tax when the pension is paid, but 25% of this is normally paid free of tax and the rest subject to income tax at the recipient’s marginal rates of tax. If in retirement the rates could be lower.
Examples – tax year 2022/23
Consider a shareholding director with £10,000 of profits to consider, assuming they are and remain a basic rate taxpayer and the dividend allowance has already been used. For simplicity, the examples have assumed no growth on investment of either the pension or extracted funds.
Basic rate tax payer |
Dividend |
Pension |
Cost to company |
£10,000 |
£10,000 |
Corporation tax @ 19% |
£1,900 |
– |
Amount paid |
£8,100 |
£10,000 |
Dividend tax 8.75% |
£708.75 |
|
Tax on pension if withdrawn* |
£1,500 |
|
Net benefit |
£7,391.25 |
£8,500 |
*Assuming income tax rates remain the same, 25% tax-free cash is taken and the residual is taxed at basic rate (20%).
Higher rate tax payer |
Dividend |
Pension |
Cost to company |
£10,000 |
£10,000 |
Corporation tax @ 19% |
£1,900 |
– |
Amount paid |
£8,100 |
£10,000 |
Dividend tax 33.75% |
£2,733.75 |
|
Tax on pension if withdrawn* |
£3,000 |
|
Net benefit |
£5,366.25 |
£7,000 |
*Assuming income tax rates remain the same, 25% tax-free cash is taken and the residual is taxed at higher rate (40%).
The pension has a clear advantage for both basic and higher rate taxpayers. Where someone is a higher rate taxpayer now but becomes a basic rate taxpayer in retirement, the benefits of the pension contribution are even greater. They could receive £5,366.25 as a dividend now or an after-tax pension payment of £8,500 in retirement.
