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Over the last couple of years, the amount of tax free dividends available to small business owners and freelancers with Ltd Companies has reduced significantly.
The reduction, which has seen the amount of dividends which can be extracted from a company without tax free go from £30k to just £2k (starting April 2018), has left some business owners switching how they extract cash from their business; one of those ways is pensions.
Not only are pensions now handy for extracting cash efficiently from a business, of course they are also there to serve their purpose in later life too.
In this article we look at how pension contributions can be tax-efficient, how to make them and how much you should be looking to pay in from your company.
Tax saving on pension contributions
You may or may not know that extracting money from a Ltd Company to pay straight into a pension comes with no tax liability.
In comparison, if a freelancer in a one man company or a small business owner, decided to extract cash from their business as a dividend they would accrue taxes charged at 0% (first £2,000), 7.5% (basic rate) or 32.5% (higher rate).
Therefore, if you do not need to use the money you would like to extract from the company you may wish to take it out and put it straight into a pension pot where it will only be taxed on extraction.
The benefits of doing this are that your pension fund will grow and you will be reducing the amount of corporation tax your business will pay as pension contributions are taken before tax is calculated; like salaries, pensions are a tax deductible expense.
The only down side to this approach is that you cannot take advantage of the governments matched contributions that are available if you make contributions to your pension pot from the salary you pay yourself from your company.
When you make contributions to a pension from your salary the government will contribute an additional 20% of what you put in. This applies to up to 100% of your salary or £40,000, whichever is less.
For example, someone on a £25,000 salary who contributes £30,000 into a pension in one year would receive a top up from the government of 20% of £25,000 but nothing on the additional £5,000 they have contributed as that is more than their salary.
Another example which illustrates where the limit impacts is someone earning £60,000 who wanted to contribute £50,000. In this scenario government contributions would only be input up to £40,000 leaving £10,000 that wouldn’t be subject to a benefit.
Salary vs Dividends
Small businesses tend to pay their directors a low salary (to take advantage of the tax free personal allowance) and then pay the balance of their allocated payment from the company as dividends. While this makes sense for income tax purposes it does mean that directors/shareholders miss out on Government added pension contributions which are limited to the salary amount which is paid.
This is because dividends are not factored into your income figure when being considered for pensions.
We should always remember that you can effectively contribute as much as you like in to a pension but as Ltd Company owners are able to do so in different ways they should ensure they take advantage of the all ways of contributing available. Consideration should be given to those which are suitable for what they would like to achieve; that may be reducing your corporation tax and saving for the future, receiving the government top up, or both.
Government Contributions vs Income Tax
You could up your salary to gain more contributions from the government but this would mean that you have to pay income tax on the salary, however, your limited company could step in and make the contribution on your behalf.
You can talk to your accountant about how your limited company can make pension contributions for you. You can also discuss your Limited Company tax and compliance obligations too if you’re unsure of those.
How make Contributions
As a small business owner you can either make pension contributions from personal bank account (the balance in which may predominately be made up of your income from your limited company) or directly from your limited company bank account.
As discussed, contribution from personal funds (your own bank account) will attract a government top up of 20% but remember this is only available up to 100% of your income or £40,000.
Contributions made straight from your limited company’s income are invested before-tax, the contribution is a tax deductible business expense and so reduces the amount of corporation tax your company pays but the contribution will be limited to the amount itself; there are no Government top ups this way.
Does “Auto-Enrolment” impact on this?
Auto-enrolment makes it compulsory for employers to enrol their employees into a pension scheme and to make additional pension contributions for them. However, if you are the only employee in your business you can opt to be exempt from the scheme by contacting the Pension Regulator.
Tax and Accounting for Pension Contributions
Every individual’s pension contribution is unique to their circumstance and while these are the rules, your method will be dependent on your income, business structure and your own pension aspirations.
If you would like to discuss your pension contributions or auto-enrolment for your employees then talk to us. Cottons Chartered Accountant’s experienced partners, knowledgeable accountants and tax advisors are best placed to guide you through pensions and ensure you are investing your money to be maximised in a tax efficient manner.
We offer a comprehensive range of tax and small business accounting services; we are also audit specialists. We have offices in Northampton, Rugby, Daventry and in London too. We are here for your business journey.