Your limited company can, literally, save a fortune into a personal pension for you, but too few business owners realise that a pension is still by far the most tax-efficient way to take money from their business, writes Tom Conner, director of Drewberry Wealth Management.
Like many clichés, the notion of the otherwise successful business owner who just hasn’t “got to grips” with the pension regime, is still mostly true. Indeed, far too many still labour under the illusion that their business is, somehow, their pension.
Unfortunately, confusing the two is likely to be one of the most expensive mistakes that any small business owner can make. For one thing, it’s a gamble that, someday, a buyer will appear and pay top dollar for your life’s work – namely a business that can continue on in your absence.
It also assumes that, once you’ve converted your business into a lump sum you can just sail off into the sunset without the need to put any of these assets into the pension regime – even though retirement income will now be your primary concern.
Lastly, it also overlooks the fact that most assets you hold outside of a pension wrapper will be added to your estate for inheritance tax purposes and subject to a charge of 40 per cent on anything over the “nil-rate band” – currently a puny £325,000 – when you die.
As a business owner, when it comes to planning your retirement, you need to remember two things: the first is that the limited company you went to all the trouble of creating exists to deliver an income to its owners in the most tax-efficient way possible. The second is that, when it comes to tax efficiency, nothing has ever come close to a personal pension as a mechanism to take money out of the business you’ve built.
There are two potential approaches and what’s best for you will depend on the state of your company’s finances and, ultimately, how you choose to take your current level of remuneration from the business. However, both approaches are still miles ahead of pinning your retirement hopes on the future sale of your business.
Approach 1: Keeping it simple
The simple way to fund a pension is to pay contributions from your post-tax salary, which means that you’ll be paying National Insurance on your contributions. Like everyone else who funds a pension in this way, you’ll usually receive tax relief at your highest marginal rate on your contributions – 20 per cent for basic-rate taxpayers and 40 per cent for higher-rate taxpayers – so you’ll effectively reclaim the income tax you pay.
Meanwhile, your pension fund will continue to grow in the tax-free environment of a pension wrapper until it’s ultimately exhausted (or you are).
But there are two key drawbacks with this approach. The first is that while you’ll receive basic-rate tax relief of 20 per cent at source, if you’re a higher-rate taxpayer you’ll need to include your pension contributions in your tax return and reclaim the additional 20 per cent tax relief you’re due via HMRC. This is naturally an additional burden and, depending on when you file your tax return, it could take over a year to receive your tax rebate.
The more pressing concern is that, for business owners who choose to take their remuneration as a tax-efficient combination of a small salary and the remainder in dividends, the maximum they could contribute (that attracts tax relief) is usually limited to 100 per cent of their salary (dividends wouldn’t count in this figure).
So, for a business owner who pays themselves the “Primary Threshold” for National Insurance, their annual pension allowance would usually be limited to just £8,164 a year.
Approach 2: Your company pays your contributions
A far more attractive option, if possible, is to have your limited company make an employer contribution on your behalf. This has a number of immediate advantages.
The first is that your company can usually contribute up to £40,000 a year (gross) to your pension – regardless of your actual salary level – and attract corporation tax relief (provided HMRC are satisfied that this contribution is wholly and exclusively for the purpose of trade).
Also, as the company pays a gross contribution, there’s no need to apply for any higher-rate tax relief you may be due via your self-assessment form. This makes it far easier to administer and means that all of your pension contribution arrives in your fund on day one.
If you’ve not made a pension contribution in the last few years, you can usually also make use of the ‘carry forward’ rules, which allow any unused allowance from the previous three years to also be utilised.
A pension represents by far the most tax-efficient way to extract cash from a going concern. Indeed, there are a good many business owners we meet who, leery of the 25-percentage point jump in dividend tax that accompanies higher-rate taxpayer status, allow excess profits to accumulate within the company.
Often, making pension contributions provides the ideal way for them to extract this capital from the business without attracting a tax charge, especially if they’re 55 or over where they effectively have instant access to their pension funds.
This compares well to the dividend route: while neither dividends nor pension contributions attract National Insurance, because dividends aren’t an “allowable expense” like pension contributions, you can’t claim corporation tax against them.
Historically, it’s often been argued that pensions only “defer” a tax bill, but that’s central to their appeal.
So long as the funds remain within your pension they continue to grow tax-free. Don’t forget that the first 25 per cent of your pension pot can be taken tax-free. You’ll then pay tax at your marginal rate on anything you draw from your pension but around 90 per cent of higher-rate taxpayers become basic-rate taxpayers in retirement (after benefiting from higher-rate tax relief throughout their working lives).
Meanwhile, assuming you die before the age of 75, your pension assets can be passed on to your beneficiaries free of tax. If you manage a longer innings, your beneficiaries will pay their own marginal rate of tax on any benefits they draw. However, your pension funds will be free of inheritance tax in either scenario.
A great swathe of British business owners who are approaching their middle years will find the pension route far more palatable than the dividend alternative, both in terms of tax efficiency and potential investment returns. The question is whether they can actually invest the time it takes to plan a worthwhile retirement.
Naturally, pensions and the tax rules involved can be complicated. The information above only provides general guidance. If you’re thinking about investing in a pension then it’s best to seek advice from a regulated adviser.
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