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Earning curve

I am a director of a recently established family business. Although I am in my early 50s, I have not made any provision for my retirement. I only draw a minimal salary from the company, preferring instead to draw dividends. This is not a strategy I wish to change, principally because of the National Insurance implications of drawing higher earnings. What options do I have in terms of pension planning?

Before discussing pension funding, I would recommend that in your current circumstances you must look at setting up an income protection plan as you would have no alternative source of income to rely on in circumstances of poor health.

Turning to pension matters, your reluctance to draw earnings from the family business does complicate matters somewhat. This is because all forms of tax-exempt pension plans limit funding levels by reference to pensionable earnings. However, the general definition of pensionable earnings does not include divid ends from shares, even shares in one&#39s own company.

Consequently, without an increase in earnings, there will only be very limited scope for you to make contributions to a tax-exempt pension plan. Having said that, there are ways of arranging matters so that earnings&#39 increases may only need to be in force for relatively short periods of time.

The most appropriate pension plans for you fall into two categories – executive pension plans and personal pension plans.

Looking at executive pension plans, contributions are linked to your length of service and pensionable earnings. First, your projected earnings are used to calculate the maximum benefits you may draw at retirement under Inland Revenue rules (no more than two-thirds of your projec ted earnings) and contributions are set so as to target that level of pension at retirement.

The plan provider will ask for your current pensionable earnings at outset in order to set a contribution limit. So, you could boost your pensionable earnings now in order to just ify a higher level of contribution for the future and the insurance company should not need to refer to future earn ings until you come close to your selective retirement age. As a result, you could inc rease earnings now and let them fall back subsequently.

A wrinkle in all this is that the plan provider may insist on averaging your earnings over at least a three-year per iod in setting a contribution limit. This is because benefit limits for directors who own more than 20 per cent of a company&#39s shares are based on earnings averaged over three or more years ending within 10 years of the date benefits are drawn.

It may be difficult to persuade an insurance company to use your expected earnings over the next three years in its current funding calculations. It is more likely that it will insist on using only the current three-year average which will be lower. You would then only be able to pay pension contributions based on your raised earnings&#39 levels after a three-year period. This would mean losing out on some years of valuable growth on the higher contributions that could otherwise be paid in now.

The new personal pension regime coming in from April 6, 2001 offers an alternative route. Currently, contributions to a personal pension scheme will be based on a percentage of that year&#39s net relevant earnings, which exc lude dividends. Con seq ue ntly, co ntributions to a personal pen sion would be very limited.

From the coming tax year, however, it will be possible to rely on the highest net relevant earnings&#39 figure for the previous five years in paying contributions to a personal pension. Thus, you could draw significantly increased net relevant earnings in the coming tax year and then pay contributions to a personal pension based on that level of earnings for the following five tax years, regardless of what your actual earnings were for those subsequent years.

You would, therefore, be free to revert to your current earnings&#39 strategy for those five years. For this purpose, your net relevant earnings will be capped at £91,800 this year, with the maximum contribution being 30 per cent of that figure, rising to 35 per cent from age 56.

The new personal pension plan rules will allow you to commence significant funding of a pension arrangement immediately rather than waiting to establish a higher three-year average of pensionable earnings.

On the other hand, the exe cutive pension plan app roach would allow much higher contributions overall once the three-year average is established and with the added benefit of a possible one-off special contribution to make up for previous missed contributions.

There are many other iss ues to consider before deciding on an executive pension plan rather than a personal pension plan. These include death benefits and tax-free lump sum entitlements among others. We can discuss these at our next meeting.

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