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Pension contributions – How they can help business owners.

How pension contributions can help business owners

The dividend tax changes have strengthened the case for business owners taking more of their profits in the form of pension contributions. Many directors of small and medium sized companies face an increased tax bill this year as a result of how dividends are now taxed. And pension contributions could provide the best outcome by cutting their future tax bills.

Dividends have long been preferable to salary or bonus as a way for shareholding directors to extract profits. But that advantage has narrowed for many high earning directors. It reinforces the case for directors taking at least part of their benefits as a pension contribution where possible.

Dividend changes

Paying themselves dividends remains a better option than salary. But the gap has narrowed for high earning directors. A director receiving a dividend of £100,000 could be £6,300 worse off under the new rules.

Everyone now gets a £5,000 tax free dividend allowance. Dividends in excess of the allowance will be taxable at 7.5%, 32.5% or 38.1%. Previously, business owners only paid tax on dividends when they took income above the basic rate tax band. That’s because the notional 10% tax credit satisfied the liability for basic rate tax payers. But the changes mean that business owners could now be paying a higher rate of tax on a larger slice of their income.

Tax efficient extraction

Pension contributions remain 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. But it’s usually an allowable deduction for corporation tax – like salary.

And of course, under the new pension freedoms, those directors who are over 55 will be able to access it 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 (but remember, by doing so, the MPAA will be triggered, restricting future funding opportunities).

In reality, many business owners will pay themselves a small salary, typically around £8,000 a year – at this level, no employer or employee NI is due and credits will be earned 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 more 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 income
taxed at 20% *
Pension income
taxed at 40% *
Gross profit  £40,000 £40,000 £40,000 £40,000
Pension contribution  £0 £0 £40,000 £40,000
Corporation tax at 20%  £0 £8,000 £0 £0
Dividend  £0 £32,000 £0 £0
Employer NI £4,850 £0 £0 £0
Gross bonus £35,150 £0 £0 £0
Director’s NI (£703) £0 £0 £0
Income tax (£14,060) (£10,400) ** (£6,000) (£12,000)
Net benefit to director £20,387 £21,600 ** £34,000 £28,000

* Assumes pension income is taxed after taking 25% tax free cash, and there is no Lifetime Allowance charge.
** Assumes full £5,000 annual dividend allowance has already been used against dividends received in the basic rate band.

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 could mean they retain their full £40,000 AA.

For example – Amy, 55, runs her own business and pays herself dividends of £150,000 for the 2016/17 tax year. She has no other income. She makes employer contributions of £20,000 into her SIPP.

There are two tests which determine whether the AA is tapered:

  1. If adjusted income is more than £150,000 the AA is reduced by £1 for every £2 subject to a minimum allowance of £10,000
  2. But only if the threshold income is greater than £110,000.

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 a further £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 into her pension as an employer contribution using carry forward of unused AA from previous tax years.  This would not affect her AA for 2016/17 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 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 from April 2017, 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 now?

There are some very strong reasons for maximising pension contributions now. Corporation tax rates are set to fall from 20% to 19% from the financial year starting April 2017, with a further planned cut to 17% from April 2020.

Companies may want to consider bringing forward pension funding plans to benefit from tax relief at the higher rate. Payments should be made before the end of the current business year, while rates are at their highest.

Business owners who take flexible drawdown  income to replace salary or dividends will see their future funding restricted by the MPAA. So they may need to pay now and mop up any unused allowance using carry forward. But remember that dipping into pension savings by only taking tax free cash maintains the full allowance for ongoing funding.

Source: Standard Life technical consulting – February 22 2017 

MPAA and Dividend Allowances cuts delayed as Finance Bill trimmed

Some elements of the Finance Bill will not go ahead as planned as a consequence of the early general election. With Parliament due to be dissolved on 3 May it was deemed there was insufficient time to get the current Finance Bill in its entirety on to the statute book.

The following measures, which may affect the advice you are providing to your clients, have been removed from the Finance Bill:

Changes which intended to apply in 2017/18

Reduced Money Purchase Annual Allowance (MPAA)
The Money Purchase Annual Allowance (MPAA) will not now be cut from £10,000 to £4,000 at this time. This reduction would have affected those who have accessed their DC pension under the new pension flexibilities and wish to continue paying into their pension.   Edit: The MPAA was indeed reduced to £4,000 for 2017-18 after all!

Deemed Domicile Rule Changes
Rules were to be introduced from April 2017 to reduce the number of years non-doms can be resident in the UK before becoming deemed domicile. Currently someone would become deemed domicile in the UK for inheritance tax after they have been resident 17 out of 20 tax years but it had been set to fall to 15 years. It was also intended extend the scope of the deemed domicile rules to also apply to income tax and CGT.

Recalculation of Disproportionate Bond Gains
Measures which would have put an end to chargeable gains on a part surrender of an investment bond have been shelved. From April 2017 HMRC had planned to allow gains which were wholly disproportionate to the investment performance to be recalculated on a just and reasonable basis. This would typically arise where a large part surrender in excess of the 5% allowance is made in the early years of the policy.

Changes which intended to apply in 2018/19

Dividend Allowance Cut
From April 2018,  the annual dividend allowance is set to be cut from £5,000 to £2,000. This is no longer part of the current Finance Bill. This would hit small and medium sized business owners who take their profits as a dividend.

What happens next?

While all these changes no longer form part of the condensed Finance Bill it is intended that they will be reconsidered once a new Parliament commences and could form part of the new Government’s first Finance Bill, meaning they may be delayed rather than dropped altogether.

Source – Standard Life