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Tony Wickenden: Is extracting company profits a good way to top up pensions?

Owner/managers may want to consider topping up pension contributions from profits extracted from their companies

Last week, I started my consideration of the most efficient means of profit extraction for owner/managers of private limited companies. The catalyst for this was the reduction of the dividend allowance from £5,000 to £2,000 in 2018/9, announced in the Budget (though this could now be delayed in the passage of the Finance Bill.)

My assumption in giving profit extraction consideration was that there was no other prior corporate use for the funds in question, for example, for business reinvestment or to repay corporate debt.

I looked at how to most tax- efficiently withdraw up to the upper earnings/higher rate tax threshold. This week I would like to examine the situation above that.

The below table shows the advantage of dividends remains but is reduced. Remember that to reach this stage, at least £4,420 of employee National Insurance contributions will have been paid.

The lack of grossing up gives dividends another advantage over salary and bonus in that gross income is kept down, as evidenced in table two.

The smaller gross equivalent achieved by paying dividends is of increased importance when the (unindexed) thresholds for the high income child benefit charge, phasing out of the personal allowance, tapered annual allowance and so on are considered. Also significant is that the gross profits cost of the dividend route is less than the salary alternative for each tax rate.

However, dividend payments are directly proportionate to shareholdings, which means the dividend or salary choice can become impossible to make when there is a mix of shareholdings and total remuneration targets.

It is also worth remembering that choosing dividend payments over a salary may have adverse effects where tests are generally salary-related, such as when applying for a mortgage.

If there is no immediate need or desire to spend the funds to be withdrawn from the company, it will usually be worth giving some thought to extraction in the form of a pension contribution.

The obvious appeal is deductibility for corporation tax, no income tax and no NI. What is more, income and gains generated by investment into the pension fund will of course be tax free.

Unpicking the pensions puzzle

When considering the alternative of a pension contribution, the first question will be whether it is possible in light of the annual allowance, tapered annual allowance, reduced lifetime allowance and any transitional protections in place. If none of these are a constraint, then the pension contribution is a completely tax-free exercise at the point of employer payment of it.

Eventual withdrawal from the pension fund will usually carry a tax cost, though. The simplest way to consider the end value is to ignore any investment return and assume an uncrystallised fund pensions lump sum is drawn; that is, 75 per cent of the contribution attracts (retirement) marginal rate tax and the other 25 per cent is tax-free.

Thus, for example, a higher rate taxpayer receives a net £700 (0.75 x £1,000 x 0.6 + 0.25 x £1,000) per £1,000 of contribution. The corresponding figures for basic and additional rates are £850 and £662.50.

Comparing numbers at this stage starts to get complicated because of the changing dividend allowance and assumptions about how any dividend drawn would be invested (remember there is a £20,000 Isa limit for 2017/18).

For a basic rate taxpayer, there is little or no advantage until the dividend allowance is exhausted. Higher and additional rate taxpayers will see more benefit, particularly if their marginal rate falls in retirement. There is no real substitute for crunching the numbers to decide what to do in any particular case once the principles are understood.

As part of the overall consideration of whether to leave funds in the company or withdraw, and how, it will be important to consider the impact on business relief (for inheritance tax) of cash left in the company and on entrepreneurs’ relief if the cash generated from trading is invested.

Tony Wickenden is joint managing director of Technical Connection. You can find him Tweeting @tecconn


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