Pension / Ltd Company Income tax efficiency quandary

scdandem

Hi and thanks for reading my question.

I run a small limited company and draw the maximum £8k ish salary to keep me under the NI threshold plus £2000 tax free dividends x 3 (spouse and daughter are also directors). All remaining profit is paid into my pension monthly.

Due to a change, the available profit going forward isn't going to be enough to continue paying the company pension contribution at the same level if I keep taking the maximum tax free salary + dividends.

I don't actually need all the salary + dividends for day to day expenses and I just take the maximum out as it's tax free and thought I should. The main aim of running my business is to fund my future pension, which I may want to start drawing down from in 18 months' time.

Ideally I'd like to keep my pension contribution as it is, or maybe even increase it, which would mean not taking full advantage of the tax free salary + dividends, but would that be a mistake? Is it more tax efficient to pay less company pension contribution then pay personal contributions from my tax free income - and is that even allowed?

Thanks in advance.

PS - apologies if this should be in the Pensions forum, it seems to span both.

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Dazed_and_C0nfused

Dividends are not tax free.  They may be taxed at 0% but it can mean you have a larger overall tax liability in some circumstances.

Have you checked your State Pension forecast, ensuring you read it in full not just the headline amount?

Not earning qualifying years may be a costly mistake as any personal pension you may be adding to is highly unlikely to ever be as good an investment as adding to the State Pension would be.

scdandem

Dazed_and_C0nfused said:

Dividends are not tax free.  They may be taxed at 0% but it can mean you have a larger overall tax liability in some circumstances.

Have you checked your State Pension forecast, ensuring you read it in full not just the headline amount?

Not earning qualifying years may be a costly mistake as any personal pension you may be adding to is highly unlikely to ever be as good an investment as adding to the State Pension would be.

?? We use the £2000 Annual Tax Free Dividend Allowance. My State Pension is fine thanks. I'm clued up re finances but just need some clarification on whether it's most efficient to take tax free income or to forego it in favour of my company paying into my pension. And whether paying tax free income into my pension is in fact allowed as I'm thinking won't have paid tax but would get tax relief on the pension payment. Clearly I might be wrong, hence the question...

Pennywise

Paying into pension is better, taxwise, than paying dividends.

To pay a dividend, you must have had profits, on which corporation tax was charged, so, say, you pay £6k dividends, you'd have already paid corporation tax of £1,407, to work backwards, you'd have needed a profit of £7,407.  So dividends aren't "tax free" as the company has already paid tax to get at the after tax profits for the dividend.

Instead, you could have paid the £7,407 as employer pension contributions, meaning no corporation tax and the full £7,407 invested in your pension.

So, you compare £7,407 in your pension, or £6,000 after tax dividends in your family's hands.

Optimum is usually:

1. Pay a salary of at least the NIC threshold (circa £8k) (mostly for state benefit purposes, not just pensions but also other benefits such that you may be eligible for such as furlough which didn't even exist 18 months ago but lots of people benefitted from whether they needed the furlough grants or not!).
2. Then pay max possible into pensions;
3. If that leaves any pre tax profit, you have a CT liability and then pay dividends out of the post tax profits.

Dazed_and_C0nfused

If you don't have any pensionable earnings you are limited to contributing £3,600/year.£2,880 that you would pay with £720 tax relief added.

If you have pensionable earnings of £8,000 you can contribute £8,000.  £6,400 that you would pay with £1,600 tax relief added.

The fact that you might not pay any tax doesn't stop you getting tax relief on "relief at source" contributions.

There is no tax free allowance for dividends, link below explains this.

https://www.litrg.org.uk/tax-guides/tax-basics/what-tax-rates-apply-me

snootleboop

Pennywise said:

Paying into pension is better, taxwise, than paying dividends.

To pay a dividend, you must have had profits, on which corporation tax was charged, so, say, you pay £6k dividends, you'd have already paid corporation tax of £1,407, to work backwards, you'd have needed a profit of £7,407.  So dividends aren't "tax free" as the company has already paid tax to get at the after tax profits for the dividend.

Instead, you could have paid the £7,407 as employer pension contributions, meaning no corporation tax and the full £7,407 invested in your pension.

So, you compare £7,407 in your pension, or £6,000 after tax dividends in your family's hands.

Optimum is usually:

1. Pay a salary of at least the NIC threshold (circa £8k) (mostly for state benefit purposes, not just pensions but also other benefits such that you may be eligible for such as furlough which didn't even exist 18 months ago but lots of people benefitted from whether they needed the furlough grants or not!).
2. Then pay max possible into pensions;
3. If that leaves any pre tax profit, you have a CT liability and then pay dividends out of the post tax profits.

If the objective is to maximise pension contributions, then can it not be better to take a dividend at a level so as to not incur tax and then make a personal pension contribution with the monies?

For example, £2,469 pre-tax profit could be used to make an employer pension contribution of £2,469. Or it could be used to pay a £2,000 dividend, which in turn could be used to make a £2,000 net (£2,500 gross) personal pension contribution.

As I see it, as long as the dividend does not create a tax liability on the recipient, the rate of Corporation Tax is lower than the tax relief available on a pension contribution and there are sufficient pensionable earnings to support such a contribution, then taking the dividend can result in a higher pension contribution than simply making an employer contribution. 

Obviously, once the dividend becomes taxable on the recipient then as you state above, employer pension contribution beats paying a dividend. 

Pennywise

snootleboop said:

Pennywise said:

Paying into pension is better, taxwise, than paying dividends.

To pay a dividend, you must have had profits, on which corporation tax was charged, so, say, you pay £6k dividends, you'd have already paid corporation tax of £1,407, to work backwards, you'd have needed a profit of £7,407.  So dividends aren't "tax free" as the company has already paid tax to get at the after tax profits for the dividend.

Instead, you could have paid the £7,407 as employer pension contributions, meaning no corporation tax and the full £7,407 invested in your pension.

So, you compare £7,407 in your pension, or £6,000 after tax dividends in your family's hands.

Optimum is usually:

1. Pay a salary of at least the NIC threshold (circa £8k) (mostly for state benefit purposes, not just pensions but also other benefits such that you may be eligible for such as furlough which didn't even exist 18 months ago but lots of people benefitted from whether they needed the furlough grants or not!).
2. Then pay max possible into pensions;
3. If that leaves any pre tax profit, you have a CT liability and then pay dividends out of the post tax profits.

If the objective is to maximise pension contributions, then can it not be better to take a dividend at a level so as to not incur tax and then make a personal pension contribution with the monies?

For example, £2,469 pre-tax profit could be used to make an employer pension contribution of £2,469. Or it could be used to pay a £2,000 dividend, which in turn could be used to make a £2,000 net (£2,500 gross) personal pension contribution.

As I see it, as long as the dividend does not create a tax liability on the recipient, the rate of Corporation Tax is lower than the tax relief available on a pension contribution and there are sufficient pensionable earnings to support such a contribution, then taking the dividend can result in a higher pension contribution than simply making an employer contribution. 

Obviously, once the dividend becomes taxable on the recipient then as you state above, employer pension contribution beats paying a dividend. 

Two issues there.

One is the the OP only gets a third of the dividend, because the other two thirds are paid to family members, so there could be anti-avoidance issues if their dividends are diverted back to the OP to invest in his pension as the shareholdings of the two family members could be viewed as a sham, with all the dividends being deemed taxable on the OP as he's the one benefitting, hence the 7.5% dividend tax comes back into play on the diverted dividends.  The family dividends need to be paid to the family members and used by them to avoid the risk of challenge.

Second, the gross pension contribution is limited to the wage, so the OP can't reduce the wage beyond the gross pension contribution, which may be problematic if profits are falling as the OP says, but he doesn't say the amount of the fall, so hard to say the effect.  The OP may not be able to "afford" the dividend, and a high enough wage to support the pension.

snootleboop

Pennywise said:

snootleboop said:

Pennywise said:

Paying into pension is better, taxwise, than paying dividends.

To pay a dividend, you must have had profits, on which corporation tax was charged, so, say, you pay £6k dividends, you'd have already paid corporation tax of £1,407, to work backwards, you'd have needed a profit of £7,407.  So dividends aren't "tax free" as the company has already paid tax to get at the after tax profits for the dividend.

Instead, you could have paid the £7,407 as employer pension contributions, meaning no corporation tax and the full £7,407 invested in your pension.

So, you compare £7,407 in your pension, or £6,000 after tax dividends in your family's hands.

Optimum is usually:

1. Pay a salary of at least the NIC threshold (circa £8k) (mostly for state benefit purposes, not just pensions but also other benefits such that you may be eligible for such as furlough which didn't even exist 18 months ago but lots of people benefitted from whether they needed the furlough grants or not!).
2. Then pay max possible into pensions;
3. If that leaves any pre tax profit, you have a CT liability and then pay dividends out of the post tax profits.

If the objective is to maximise pension contributions, then can it not be better to take a dividend at a level so as to not incur tax and then make a personal pension contribution with the monies?

For example, £2,469 pre-tax profit could be used to make an employer pension contribution of £2,469. Or it could be used to pay a £2,000 dividend, which in turn could be used to make a £2,000 net (£2,500 gross) personal pension contribution.

As I see it, as long as the dividend does not create a tax liability on the recipient, the rate of Corporation Tax is lower than the tax relief available on a pension contribution and there are sufficient pensionable earnings to support such a contribution, then taking the dividend can result in a higher pension contribution than simply making an employer contribution. 

Obviously, once the dividend becomes taxable on the recipient then as you state above, employer pension contribution beats paying a dividend. 

Two issues there.

One is the the OP only gets a third of the dividend, because the other two thirds are paid to family members, so there could be anti-avoidance issues if their dividends are diverted back to the OP to invest in his pension as the shareholdings of the two family members could be viewed as a sham, with all the dividends being deemed taxable on the OP as he's the one benefitting, hence the 7.5% dividend tax comes back into play on the diverted dividends.  The family dividends need to be paid to the family members and used by them to avoid the risk of challenge.

Second, the gross pension contribution is limited to the wage, so the OP can't reduce the wage beyond the gross pension contribution, which may be problematic if profits are falling as the OP says, but he doesn't say the amount of the fall, so hard to say the effect.  The OP may not be able to "afford" the dividend, and a high enough wage to support the pension.

Good points - I was just musing about Director owned companies in general rather than the OPs specific situation, but as you say the fact there are other shareholders does complicate things.

One - I wasn't suggesting that the wife/daughter pass money back to OP to make a pension contribution. As you say, they would need to make contributions in their own name. Not the worst idea for the wife to make her own pension contributions and build up two pots for retirement so as to be able to utilise two Personal Allowances etc. (presume that she would not pass the wholly & exclusively test and that is why current employer contributions are solely going to OP?). The daughter being a shareholder is more of a complication as OP and wife will not have access to any dividends paid to her. My point was more about extracting as much benefit in monetary terms as a collective, but as you point out, this doesn't work if the OP is instead looking to maximise personal benefit.

Two - fair point about personal contributions being limited to salary, but as the OP will always be looking to draw c£9.5k salary first for NI purposes then is it not generally going to be irrelevant? "Tax free" dividends will usually be limited to the £2k Dividend Allowance and any unused Personal Allowance (c£3k) so unlikely to be a case where the full dividend cannot be contributed into pension due to lack of earnings to support the contribution. If profits fall so that the salary cannot be supported then OP would not be looking to make employer pension contributions or pay dividends anyway.

In general, would it be more optimal to add the following step into your order?

1. Pay a salary of at least the NIC threshold (circa £8k) (mostly for state benefit purposes, not just pensions but also other benefits such that you may be eligible for such as furlough which didn't even exist 18 months ago but lots of people benefitted from whether they needed the furlough grants or not!).
1.a. Pay a dividend of such a level that would not create a tax liability on the recipient and use funds to make a personal pension contribution.
2. Then pay max possible into pensions;
3. If that leaves any pre tax profit, you have a CT liability and then pay dividends out of the post tax profits.

Or am I missing something? I suppose there would be slightly more admin involved as there would then be an employee contribution that needs to be made as well as a potential employer contribution?

Grumpy_chap

scdandem said:

Hi and thanks for reading my question.

I run a small limited company and draw the maximum £8k ish salary to keep me under the NI threshold plus £2000 tax free dividends x 3 (spouse and daughter are also directors). All remaining profit is paid into my pension monthly.

Due to a change, the available profit going forward isn't going to be enough to continue paying the company pension contribution at the same level if I keep taking the maximum tax free salary + dividends.

I don't actually need all the salary + dividends for day to day expenses and I just take the maximum out as it's tax free and thought I should. The main aim of running my business is to fund my future pension, which I may want to start drawing down from in 18 months' time.

Ideally I'd like to keep my pension contribution as it is, or maybe even increase it, which would mean not taking full advantage of the tax free salary + dividends, but would that be a mistake? Is it more tax efficient to pay less company pension contribution then pay personal contributions from my tax free income - and is that even allowed?

Thanks in advance.

PS - apologies if this should be in the Pensions forum, it seems to span both.

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OP - do you have an Accountant?  They arebest placed to advice you on this.  If yo do not have and Accountant, then it would be very sensible to get one.

Others have commented on the various tax options and balance between CT / IT / NI / Pension.  I won't add anything, other than asking whether you have other earned income on which NI is paid?  If not, paying below the NI threshold may be sacrificing certain state entitlements, in particular state pension.

What particularly strikes me from your post is that everything is written in the first person, yet the earnings from the company are shared between three recipients.
"I don't actually need all the salary + dividends..."
"I just take..."
"...thought I should"
"...my future pension"
"...I'd like to keep my pension contribution as it is..."

Unless the split share ownership is a sham, the other shareholders may have something to say about the reduction in business income being managed to result in a reduction of dividend payout but maintaining (or increasing) the employee pension at the same time.  Why has the business income reduced?  If it is because the employee approaching retirement is working fewer hours, then why would the business owners support the salary level being maintained?

You don't say how old your daughter is.  If she is young, then her being a shareholder may be very questionable.  If she is older (which I assume is probable given you state your intention to start drawing the pension in less than two years), then her having this dividend income may impact her entitlement to any other benefits, or may give rise to a tax liabilty elsewhere (for example if she has an employee share scheme that pays dividend that would otherwise be within the zero percent dividend allowance).

Irrespective, the dividends paid to your wife and to your daughter should be paid to your wife and to your daughter for them to then do whatever they wish with the funds.  The dividends paid to others cannot simply be treated as your own.

Full circle to my first comment that your Accountant is the best placed to advise, with benefits and pitfalls all properly considered.

Grumpy_chap

Pennywise said:

the gross pension contribution is limited to the wage, so the OP can't reduce the wage beyond the gross pension contribution, 

snootleboop said:

fair point about personal contributions being limited to salary, 

I thought pension contributions of up to £40k were normally permitted even if that exceeds salary.
I may be incorrect.

scdandem

Grumpy_chap said:

Pennywise said:

the gross pension contribution is limited to the wage, so the OP can't reduce the wage beyond the gross pension contribution, 

snootleboop said:

fair point about personal contributions being limited to salary, 

I thought pension contributions of up to £40k were normally permitted even if that exceeds salary.
I may be incorrect.

This one confuses me too. As I understand it, you're limited to £40k or 100% of your earnings when making Personal pension contributions but there's no limit when it's an Employers contribution? That's the basis I've been working on for years so I hope I'm right or I'm going to be up the creek!