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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

Tax Year-End: Do you want to make more than £40,000 pension contributions this year? – Carry Forward!

The annual allowance for pension contributions in 2014-15 is £40,000, which is the gross equivalent and includes all contributions from all sources (i.e. incl. employer contributions). Unused allowances from the previous three years may be carried forward and used in the current tax year.  (You need to have been a member of any UK pension scheme in a given tax year to qualify for the contribution allowance in that year).

Carry forward of pension annual allowances can have its intricacies, but basically you must first use the current year’s and then work backwards. All of the tax relief obtained is applied against current year’s income. The annual allowance was £50,000 in each of 2011-12, 2012-13 and 2013-14 (so potentially an individual could pay up to £190,000 into pensions in the current tax year).

Please give me a call if you are interested in any last minute lump sums into pensions.

New Pensions Rules – Budget 2014, or “Look what they’ve gone and done now….”

In case you missed the content of the Budget here’s a handy link to a concise, printable document which sets out the facts and figures: March 2014 Budget Summary

I’m still shaking my head over the proposals to allow all people in money purchase pensions (non-final salary) to have unlimited (“flexible”) drawdown on their pension pots at retirement age, regardless of size of fund and without any necessity for a level of guaranteed income from another source. The sentiments below will no doubt be at odds with many with an interest in the subject. Certainly the media and various industry pundits appear mostly in favour of this new found relaxation of the rules.  Many people approaching retirement are now looking forward to planning what they will do with their fund, and financial advisers are looking forward to more cash investments to advise upon. There is no doubt that this will bring opportunity to many, but I’m wary. This all sounds like a bit iffy to me.

The main justification offered by the Chancellor for the proposed relaxation of pension rules announced last week is that “people who have been responsible enough to save all their lives for their retirement will be responsible with their money in retirement, and should have the freedom of choice”.  Sorry, I simply do not buy that. I think there are some likely adverse socio-economic effects, which could be on a wider scale than predicted. I have a number of concerns:

A huge number of working people in the UK (millions, literally) aren’t currently saving in a pension, but soon will be (shoe-horned into one via Auto-Enrolment (“AE”) regulations.)Many of this category of pension saver would not have saved in a pension otherwise, will have a smaller pension pot than average at retirement age, and, being reluctant savers, are more likely than most (in my opinion) to spend the cash quickly when given access to it. AE is a fine idea which compels those not saving for their own retirement to at least take some modest steps towards doing so, and so helps improves income in retirement. In my opinion, to then offer such pension savers the whole fund back as a potential lump sum undoes a lot of the good that AE brings.

For other pension savers, the temptation to strip out large chunks will be great for a variety of reasons. Who, in their sixties, hasn’t got a son, daughter or grandchild who is struggling financially? Maybe they cannot get on the housing ladder , or need some other important financial assistance. How many wouldn’t consider making a loan or gift from this pot of gold which is now accessible from the Bank of Mum and Dad?  The tendency in this country is for parents to assist their offspring far beyond age 21, some with an amazing capacity for selfless acts. That money isn’t going to end up looking after the parents in old their age after all.

‘Ah’, you say, ‘but they can invest that money in something other than an annuity now’. Well, yes but you could pretty much do that under SIPP drawdown anyway, apart from investing in residential property. SIPP drawdown was not an exclusive club at all, but it did require financial advice under strenuous compliance to ensure it was suitable to the client. How much depth of advice can be given under this “free financial advice for all retirees” being bandied about I wonder?

Consider also the more sinister effects of the proposed changes. For example, there will be instances where avaricious no-good kids will be looking at mum or dad’s pension and counting the days to retirement, when they can bully a serious chunk of cash from them. Not very likely? I’ve seen it with equity release in the past with children making unsubtle enquiries “on behalf of their parents”, and this will be a much easier way for them to try and raise some quick cash.

Some will call these regulatory changes a great opportunity, a freedom to carve up one’s pension any way you choose, and something that people want. But the whole idea of a pension is to provide an income for life, that is what separates it from other types of saving. It’s not a rainy day savings plan, it’s a rest of your life savings plan. Common sense suggests that many people who will retire under the new proposed regime will not be capable of managing their financial affairs suitably, and would have been financially better off with a compulsory annuity, or even capped income drawdown if they fit the suitability criteria.

More generally, let’s face it, we don’t know how long we will live, people have never had this much access to pensions before, and simply being in a pension plan half your life doesn’t make you super-sensible with money. The fact that so many people accept poor annuity offers from their pension providers at the point of retiring, rather than look to the open market, is a good example of how financially savvy people aren’t when left to their own devices.

“… But we’re going to get everyone financial advice for free at retirement”. How does that work then? I don’t know financial advisers who work for free. Someone will pick up the cost so who will it be? The retiree ultimately. I suspect. And how good will that advice be?

No-one was lobbying government for this per se. There has been a recent upswell of criticism of the annuity industry (most of it well-founded) but that could be sorted out, even if a little more regulation or legislation was needed.  So why now?

Contrary to the political spin, I believe the proposed relaxation of rules on pensions is likely to see many retirees releasing money from their pensions relatively quickly, who would be better advised not to do so. If that happens then it will raise tax revenues for a few years in the shorter term, maybe even plug an income gap for government that is no doubt sorely needed. But it would be a short-term injection. Will everyone blow their pension funds and then throw themselves on the mercy of the State for a basic income for the rest of their lives? No, but some will, at least, and perhaps quite a few.  The Chancellor claims that the proposed new flat-rate State pension with no means testing would be an adequate safety net. At around £7,000 per year I have my doubts. Moreover, I also have severe doubts as to whether the State can maintain that level of flat-rate State pension in real terms over the long term. Of course the current mob in power will have moved on or retired by then (on their generous State-funded final salary pensions).

This is scary stuff folks. I know everyone thinks it’s great, a brave message from pensions minister Steve Webb, but I don’t think the British working public are ready for it yet. By all means extend flexible drawdown, and by all means reform the annuity industry. But let’s not completely throw caution to the wind eh? Because the country cannot afford to keep getting things like this wrong. All eyes will as usual be on the next generation to fund State pensions and other benefits, and let’s face it, with an ageing population and an unfunded State pension, they’re already going to have to pay for enough as it is.

Pensions – The Lifetime Allowance cut April 6th 2014

Don’t snooze or you might lose. (OK I know pension rules are a tad dull but read on it’s important.)

The Lifetime Allowance is being tinkered with again! A year ago it was announced that the pensions lifetime allowance will drop at the end of the (current) tax year 2013-14 from £1.5million to £1.25 million. Remember, if you exceed the allowance, the excess is liable to be taxed at 55%.

Many more people are going to be affected by this than the Government suggests – a major pensions company estimates 360,000+.  Who  should care? Well, for starters anyone with aggregate pensions  (including final salary) currently valued at more than £1.25 million who hasn’t any existing protection from HMRC.  But also anyone in danger of getting close to that limit in the years to come (don’t expect Government to put it back up again anytime soon). The graph below shows the LTA since inception in 6/4/2006 (“A-day”) and perhaps suggests a trend (source = Standard Life):

Pensions Lifetime Allowance LTA chart

Lifetime allowance 2006 to date

Who’s in danger of falling foul of the latest rule change then? Well, of course it depends on how much aggregate pensions you have now, what your current funding level is and how long to go until your likely retirement date – but some simple maths produces the following table as a guide for members of money purchase schemes (i.e.  group personal pensions, occupational money purchase schemes, executive plans, RACs (S226s), S32s, i.e. anything not final salary) as follows:

Fund level now (without further contributions) to achieve £1.25 million
Years to Retirement Fund now growing at 4% Fund now growing at 6%
3 £1,111,245 £1,049,524
5 £1,027,409 £934,073
7 £949,897 £831,321
10 £844,455 £697,993

And that’s assuming you make no more contributions to any plan!

Likewise for those lucky enough to have a defined benefit (final salary) pension (the calculation is 20x the annual benefit, so £62,500 per year is where it max’s out):

(Deferred) Annual Final Salary Pension level now to achieve £1.25 million
Years to Retirement Pension revaluing at 3% p.a. Pension revaluing at 4% p.a.
3 £57,196 £55,562
5 £53,913 £51,370
7 £50,818 £47,495
10 £46,506 £42,223

The table above assumes you’re no longer an active member of the scheme / adding years!

Don’t forget to aggregate your money purchase and final salary pots together.

What to do?

There are two new options to lock into the current higher allowance:

“Fixed protection 2014” allows clients to lock into the old £1.5m allowance beyond 2014. The down-side is that pension savings have to stop after 5 April 2014. You must apply for this by 5 April 2014.

“Individual protection” is only available to clients with pension savings worth more than £1.25m on 5 April 2014. It gives a personal allowance equal to that benefit value on 5 April 2014 (i.e. up to £1.5m), and importantly it doesn’t mean giving up on pension saving. You must apply for this by 5 April 2017.

It’s a complicated issue though and might require regular monitoring of all your pension accounts.  There are many potential angles to this and not all are obvious. For example, maybe you think you’re a marginal case? Well perhaps de-risking your pension investments works for you – e.g.  if  a steady lower risk, lower return portfolio probably keeps you below the limit, but a higher risk approach (always assuming it does achieve higher returns)  is likely to take you over it – in which case do you really want to take risk chasing higher returns  when the Government stands to get most of the benefit? Just one example of things to think about.

The simple message is get to advice from a good independent pensions adviser   …………..(hmmm…  Oh! Hello …… ) if you are in any way concerned about this. We can look at various scenarios and discuss solutions and the alternatives which suit your particular circumstances and give you the best results when you do actually retire.

Income Withdrawal – What’s the low-down on Drawdown?

This post deals with a few of the key points concerning drawdown contracts. A more complete analysis of drawdown vs. annuities can be found in the Honister booklet available at this link.

A recent change in the rules has allowed people to enjoy a new option: “flexible drawdown” which allows pensioners to have complete flexibility over the sums they withdraw from their drawdown contract (subject to normal income tax), provided that they can pass a new minimum income requirement (“MIR”) of £20,000 per annum from other means. So, provided that you can prove to the Revenue that you have at least £20,000 of secure annual income p.a. in retirement from alternative sources, such as a final salary pension scheme or other annuities, you may withdraw as much as you wish from your flexible drawdown plan.

The flexible drawdown MIR is a one-off test, and once it has been satisfied you do not have to prove your income again in later years.

This contrasts, however, with another amendment in regulations which serves to reduce the maximum annual sums others may withdraw from their contracts, (i.e. those who cannot meet the new MIR statement of income from other means and so are presumably more dependent on their drawdown plans). They could previously withdraw up to 120% of the government actuarial department (GAD) prescribed limit, but this has now been reduced to 100% (in simple terms, the GAD limit is close to the £ amount that one might receive from a level single life annuity). This reduced GAD limit will apply from the next review of an existing drawdown plan.

One of the things that people forget about drawdown plans is that they may be converted into an annuity at any time. So if nothing else, they can be used to defer annuity purchase, especially for younger pensioners. But perhaps their greatest advantage over annuities is that after the death of the policyholder, a surviving spouse or dependent relative may simply take over the plan and continue to run it, without any special tax charge relating to the takeover. Thus the spouse / dependent relative (who will still be subject to income tax on the income), enjoys the benefit of the plan and may themselves convert it into an annuity for themselves in the future.

This is only a snapshot covering a few key issues. Give me a call on 0845 013 6525 and I’ll be happy to discuss drawdown and annuities in the context of your own retirement planning objectives.