Techzone

Owners of SME companies will be considering the best way to take profits from their business as the tax year end nears.

The dividend route has been favoured by many in recent years, but there has always been a strong argument in favour of pension contributions. In part, this is because dividends are paid after corporation tax, whereas an employer pension payment is an allowable deduction from profits before corporation tax. This year the main rate of corporation tax has risen to 25%, making the pension option even more compelling.

This advantage can be exploited further as the annual allowance has increased to £60,000 and tapering does not kick in until the client has income of £260,000. If tapering does apply the minimum annual allowance is £10,000, up from £4,000. And of course clients no longer have to worry about attracting a lifetime allowance charge on amounts saved.

Tax efficient extraction

Business owners will look to benefit from their hard-earned profits in the most tax efficient way. When paying themselves for day-to-day living, the choice will usually be between salary/bonus or dividend. Dividends are paid after corporation tax and the dividend rates are less than the income tax rates on salaries. But the rise in corporation tax this year, coupled with the dividend rate rise in 2022/23 and the reductions in the dividend allowance since it was first introduced have reduced the gap between salary and dividends.

Ultimately, the decision will largely be based on the income levels required and the actual rate of corporation tax. The main rate of corporation tax this year is 25% for companies with annual profits over £250,000, reducing on a sliding scale to 19% for companies with profits less than £50,000.

In reality, many business owners may pay themselves a mixture of both salary and dividend. But what about profits in excess of their living needs?

Due consideration should be given to a pension contribution. It is an allowable deduction from profits subject to corporation tax, just like salary or bonus, but unlike salary or bonus there's no employer or employee NI liability - just like dividends.

And for those who do need access to maintain normal living standards, a modern flexible pension will allow directors over 55 can access it as easily as salary or dividends. With 25% of the pension pot normally available tax free, it can be very tax efficient - especially if the income from the balance can be taken within the basic rate. But remember that taking drawdown income will trigger the MPAA, potentially restricting future saving options.

Example

The table below compares the net benefit ultimately derived from £10,000 of gross profits to a higher rate taxpaying shareholding director in the 2023/24 tax year.

* Assumes annual dividend allowance has already been used.

There is not much between the net value to a director between the bonus and dividend routes. The outcome may change slightly if any or all of this year's £1,000 dividend allowance is available. But if the director doesn't need this income, the value in their pension pot is almost double what they would receive by taking a bonus or dividend.

When the client takes money from their pension during their lifetime to support their retirement, the figures still compare favourably. If the £10,000 fund is taken when the director is a basic rate taxpayer, net spendable income will be £8,500** (or £7,000** if taken as a higher rate taxpayer). For the figures in this example, that is respectively 67% and 37% more than the bonus option, and 71% and 41% more than the dividend option.

** Assumes pension income is taxed after taking 25% tax free cash. Growth has been ignored.

Scotland

The above figures are based on the main UK rates and allowances. The income tax rates on earned income are higher in Scotland which would reduce the net benefit to directors under the bonus option. Similarly, pension income drawn by the member during their lifetime would be taxed at higher rates than the rest of the UK in most cases.

Wealth transfer

With regards to family wealth transfer the full pension fund will normally be paid tax free on death before 75, and at the beneficiary's marginal rate of income tax for amounts taken where the member died after age 75. In addition, the pension wrapper offers protection from IHT as well as tax the income and gains on investments.

Tapered Annual Allowance

Although there is no longer a penalty on the size of pension funds, the amounts that can be paid in are still limited. Many high earning business owners with 'adjusted income' in excess of £260,000 could see their annual allowance (AA) tapered down to just £10,000. Adjusted income broadly includes earnings, employer contributions and other income. However, reducing what they take in salary or dividends and paying themselves a larger employer pension contribution instead could mean they retain their full £60,000 AA. This is because contributions of this type should not be viewed as salary sacrifice, and therefore will not count towards their 'threshold income'.

Why now?

With the tax year end approaching, there are several reasons why your clients may benefit from making an employer pension contribution now:

• Avoid AA tapering - to ensure that this year's annual allowance is not tapered. Remember bonus and dividends count towards the £200,000 threshold income, but employer contributions normally don't.
• Use full pension allowance - to use up any annual allowance carried forward from 2020/21, which would otherwise be lost.
• Deliver more tax efficient income - so that profits which may otherwise be taken as bonus or dividend don't boost income to the point where the personal allowance is lost, or the child benefit tax charge applied.
• Create a tax efficient legacy – pensions typically don't form part of the estate for IHT.
• Get in shape for retirement - to maximise tax efficient funding if they shortly plan to reduce working hours pre-retirement and start to draw pension income, at which point any future funding will be restricted to the money purchase annual allowance of £10,000 and unused carry forward allowances lost.