By Dante Peters
Every small business owner wants to turn their hard work into profit. But, earning is only part of the process; equally important is extracting those profits from your business, in the most tax-efficient way possible.
Most business owners take profits out as dividends. However, in April 2018 the dividend allowance was reduced to just £2,000, meaning it’s not as tax-efficient as it once was to do so.
Well fear not. If you don’t need all your profits right now, why not take them as an employer pension contribution, so that you can use the money later on in life?
Taking money out of your business
Despite a reduction in the annual dividend allowance, taking your company’s profit as a dividend is still more tax-efficient than taking it as a salary. If you were to take profits as a salary, you’d be paying away 40% in income tax, 13.8% as an employer NI contribution and 2% employee NI. If you took a dividend, you’d be suffering less tax; 19% of your profits would go on corporation tax, while dividend tax would be 32.5% on the remainder.
An employer pension contribution would mean even less is lost to tax. You’d have no NI liability, and your corporation tax liability should reduce too.
You may think that by taking a pension contribution, you’ll effectively lock away your money until your retirement. But, don’t forget you can access your pension from age 55, the first 25% of which is tax-free. Although it’s worth remembering that, if you do start to drawdown your pension, your Money Purchase Annual Allowance (the relief you get on paying money into your pension) may reduce.
Let’s do the maths
Most business owners take a small salary of around £8,000. This helps build up your state pension without triggering the need to pay NI. The remainder of your earnings would typically be paid in dividends. But, what if you put some of those profits into your pension instead? The table below details the tax implications of taking £40,000 as either a salary, dividend payment, or a pension contribution:
*Assumes full £2,000 annual dividend allowance has already been used.
Even when you take the money out of your pension, it will still be worth more. If you’re a basic rate tax payer, a £40,000 contribution will be worth £34,000** when you drawdown your pension, or £28,000** if you’re a higher rate payer.
** Assumes pension income is taxed after taking 25% tax free cash, and that there’s no Lifetime Allowance charge. Growth has not been calculated. Based on main UK tax rates and allowances: not Scotland.
Other benefits to you
There are other reasons why taking a pension contribution could be the right decision for you:
- It could help with annual allowance (AA) tapering. If you reduce the amount you’re taking as salary and dividends, and increase your pension contributions, you could protect your AA. Pension contributions are not viewed as salary sacrifice and won’t therefore count towards your ‘threshold income’, but will count towards adjusted income
- It could also help you protect your personal allowance, and child benefits
- Pensions don’t typically form part of an estate, so boosting your pension could also help you build a more tax-efficient legacy for loved-ones
Tax efficiency is such a huge part of financial planning, and if you get it right, your money could work harder and more effectively for you. But central to your planning is being clear on your long term goals. If you want to wind your business up in the next 10 years, then the decisions you are making now, about how you take any profit from your business, could be very different, than if you have plans to keep the business going for longer than 10 years.
As ever, when you’re considering these things, it is always best to seek professional advice before making any further contributions.
Note: You will also need to consider the lifetime allowance, which is currently £1,055,000; anything over this is liable to be taxed. If you have lifetime allowance protection, again, you should seek professional advice before making any further contributions.
Past performance is not indicative of future performance.
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