Company Pension Contributions That “Pay Dividends”

It is five years since I originally wrote the above titled article. Since then company pension contributions have recently become even more attractive than before for three reasons:

The annual pension allowance has increased from £40,000 to £60,000.

The corporation tax rate has increased from 19% to 26.5% on profits in excess of £50,000 and 25% on profits in excess of £250,000.

The dividend tax rate has increased by 1.25% across all tax bands.

The rest of this article is the same as before, however, I have updated where relevant to take account of current allowances and tax rates.

We often encounter successful business owners with growing cash balances in their company. A healthy amount of cash in any business is sensible as it can help fund emergency expenditure, growth and expansion. Beyond this however, accumulating cash can become inefficient and a great deal of thought is often given as to how best to draw some of this hard-earned profit from the company. Whilst the most common way to realise money from a business is to draw income via salary or dividends, this can also be unattractive due to the gradual loss of one’s personal allowance once personal taxable income exceeds £100,000.

In line with the above, one of the most common questions business owners come to us with is:

The answer, almost always, starts with considering company pension contributions.

Unlike personal pension contributions, contributions paid directly from a trading company are paid gross and can be treated as a business expense. Furthermore, everyone starts with an annual personal pension allowance of £60,000 (1) and can carry forward up to three years of unused allowance. This equates to a potential contribution of up to £180,000 in 2023/24.

Consider the following example and chart (located below this article) which illustrate just how tax-efficient these contributions can be compared to being drawn as a dividend:

Dividend Income

Every £1 of profit made in a limited company is subject to corporation tax at 25%, leaving 75p. When that 75p is drawn as a dividend, assuming that the director is a higher rate tax payer, it will be taxed as income by a further 33.75%. This reduces the net profit of 75p to just less than 50p. In total then, £1 of profit dramatically reduces by more than 50% to just under 50p when drawn as a dividend from the business.

Company Pension Contribution

If £1 of profit is instead paid by the company into a pension, it can be treated as a company expense and no corporation tax is due. Furthermore, there will be no income tax meaning that the pension receives the full £1. Therefore, by opting to make a company pension contribution instead of drawing a dividend, 50p has turned into £1. This uplift is equivalent to achieving a 100% return on day one, or 7.16% compounded over 10 years which is quite incredible when you consider that unlike Venture Capital Trusts or Enterprise Investment Schemes, those monies do not have to be invested in any particularly high risk or unusual investment strategy.

Based on the figures above, a company making a £100,000 contribution on behalf of a director would result in an effective tax saving of at least £50,000.

The benefits don’t stop there. Under current rules, pensions do not form part of your estate which can make them an effective estate planning vehicle and whilst in your pension can grow free of any tax. Furthermore, when you come to draw funds in retirement, you are entitled to draw 25% of the fund tax-free (2). There is potentially some tax to pay later as funds drawn in excess of tax-free cash are taxed as income at your marginal rate, however you have complete flexibility to ensure that any such income is drawn in a tax-efficient manner. For example, we aim to position a client’s income so that they remain within the basic rate band throughout retirement where possible by using various investment wrappers.

In summary, company pension contributions remain one of the last ways to enjoy a truly risk-free return. As such, when directors are looking at tax-efficient ways to draw money from their business, this option should be very near the top of their agenda.

If you would like to discuss how you might be able to benefit from company pension contributions, please get in touch.

Written by Philip Feast

1 In some circumstances this can be impacted/reduced where taxable income is in excess of £200,000.

2 Usually subject to a maximum of 25% of the lifetime allowance relevant to that individual.