Using pensions to take tax-efficient business profits

Alan, aged 56, owns a limited company. Each year he reviews his remuneration strategy at the end of his reporting period on 31 December. The approach he has taken to date is a low salary topped up by dividends.

The business has generated £100,000 of profit in 2015 and Alan uses the remuneration he takes out in December each year to meet his income needs for the year ahead.

Alan is aware rules on dividend tax will change in 2016 and so wants to meet with his adviser to understand the impact of the changes on his remuneration strategy. He would also like to take as much money as possible out of his business before the dividend tax treatment changes.

Alan does not save into a pension as he believes there is sufficient value in his business to meet his future income needs in retirement.

The tax position

In order to achieve maximum tax efficiency, under the current rules and using his usual remuneration approach, Alan would take a salary of £8,112 and the remainder needed to meet his income needs as dividends. This approach assumes normal personal allowances, tax rates and National Insurance apply.

This method will give Alan £70,950 in his own bank account and HM Revenue & Customs will have total receipts of £29,050. For 2016/17 this will change to £67,039 in Alan’s own bank account and HMRC total receipts of £32,961, assuming in both years the company profits are wholly extracted.

However, during the meeting with his adviser, they work out Alan only actually needs £3,900 per month to meet his spending needs in 2016.

Based on this lower monthly figure, Alan would have around £24,000 left in his personal bank account at the end of the year.

The solution

Alan’s adviser explains that should he go ahead with his usual approach, taking out more than he needs, not only will he pay more in dividend tax but his company will pay more in corporation tax.

He goes on to explain that should he decide to “give up” the unnecessary £24,000 in his own bank account, the company would instead be able to invest £40,000 into a pension as an employer contribution. Doing this would save the company £8,000 in corporation tax. The investment would, of course, be subject to the whole and exclusively rules. By taking this approach, Alan will not only have pension savings that are not directly linked to his business, giving him greater flexibility when he chooses to retire, but he will also pay less in tax to HMRC. Having invested £40,000 in a pension, this would leave £46,950 in Alan’s bank and produce HMRC receipts of £13,050. And if replicated for 2016/17 the figures would be £40,000, £45,439 and £14,561 respectively.

As Alan is over the age of 55, he already has the flexibility to extract money from his pension at any time if he requires extra income, although any flexibilities accessed would trigger the money purchase annual allowance.

If, when he retires, Alan decides to take 25 per cent of his pension savings as tax-free cash and the remainder is taxed at basic rate, he will have turned the original £24,000 that would have been left in his business bank account at the end of 2015 into £34,000 (£10,000 pension commencement lump sum plus £24,000 (£30,000 x 80 per cent)) through a pension to meet his future spending needs. If he is still a higher rate taxpayer this figure would be £28,000. As an additional rate taxpayer it would be £26,500.

By simply taking what he needs to live on now and then funding a pension with the spare money, Alan is extracting the profit from his business in a more tax-efficient manner.

This approach has the added benefit of giving him an alternative income stream that he could use in the future if the business has a poor year or if he cannot sell it at the point he wants to retire. It could also make up for any shortfall in his anticipated value of the business when he retires.

By saving into a pension Alan is also diversifying his retirement planning by moving away from effectively investing in a single company’s shares (his company) to pension funds, potentially multi-asset, that have been identified by his adviser as appropriate to his attitude to risk and savings needs.

As a final bonus, Alan’s adviser points out the money saved into a pension would be protected from creditors should the business fail and go into administration. While Alan may have been initially sceptical of saving into a pension, the benefits highlighted by his adviser are difficult for him to ignore.

Mark Devlin is technical manager at Prudential