Alongside this, there is often the question of how a director’s pension can be provided most tax-efficiently. The NI saving means it is better for the company to make a contribution than to pay an equivalent amount in salary to the individual who then contributes.
What is less clear-cut is whether it is better for the company to pay into the pension or to pay a higher dividend which can then be invested by the individual. NI is not payable in either case, so it becomes purely an issue of weighing up the income tax and corporation tax implications.
Changes to the lower rates of income and corporation tax this year have simplified the position. Now that the small company rate for corporation tax (21 per cent) is higher than the basic rate of income tax (20 per cent), the balance has swung towards employer contributions for all sizes of company. It also makes no difference whether earnings take the individual into higher-rate tax. If a company pays the contribution, the gain compared with the individual paying is 11 per cent if profits are over £1.5m, 14 per cent if profits are between £300,000 and £1.5m and 1 per cent if profits are under £300,000.
However, there is one situation where there is a tax benefit in the dividend being paid and invested in pension by the individual. This is where earned income is well within the basic-rate band but substantial dividends take the individual into the higher-rate tax bracket.
Let us assume that Peter is the 100 per cent director of a company with profits under £300,000 a year. He draws a £10,000 salary but dividends take him well into the higher-rate tax bracket. He pays £8,000 into a pension, grossed up to £10,000 with basic-rate relief. His basic-rate tax band is then extended by £10,000, meaning that higher-rate tax is not payable for an equivalent amount of deemed dividend income.
Reducing deemed dividend income by £10,000 saves him £2,250 in higher-rate tax (32.5 per cent minus 10 per cent tax credit). The cost of the contribution is therefore £5,750 (£8,000 minus £2,250).
If the company had paid the £10,000 contribution, the dividend paid to Peter could have been reduced by £7,900 after corporation tax at 21 per cent. With the 10 per cent tax credit, this would gross up to £8,778 and Peter would be liable to 22.5 per cent tax on that, coming to £1,975. Deducting that from the £7,900 gives a net reduction to Peter’s post-tax dividend income of £5,925, which is effectively the cost to him of his company paying the pension contribution. In this situation, Peter gains around 3 per cent by making the contribution himself instead of the company paying it.
There are two key factors. The first is that Peter is a higher-rate taxpayer because of dividend income rather than earnings and the second is that company profits are under £300,000 for the year. If either of these had not applied, company pension contributions would have been the better route.
There is one other caveat. Tax relief on contributions by individuals is only available up to the level of their earnings. If earnings are low and the bulk of income is through dividends, then the maximum contribution qualifying for tax relief could be lower than the individual wants to pay. There would be no benefit in increasing earned income and NI simply to make pension contributions slightly less expensive. A combination of employer and individual contributions might be the answer.
In reality, the differences are small for companies paying 21 per cent corporation tax and decisions are likely to be driven by factors other than tax reliefs on pension contributions.
Ian Naismith is head of pension market development at Scottish Widows