SWAP DIVIDENDS FOR COMPANIES PENSION CONTRIBUTIONS?

As a rule of thumb, the most tax-efficient way to extract profit from company are dividends. However, company and personal circumstances can change that should you consider pension contributions?

Tax and profit extraction

Since April 2016, Several measures has introduced by the government that have eroded the personal tax advantages for director shareholders of companies, in particular increased income tax on dividends. Nevertheless, with few exceptions’ dividends produce the greatest net income for shareholders compared with taking income in other forms, e.g., salary or benefits in kind. However, you should consider reducing dividends in favour of pension contributions for longer term tax efficiency. If you don’t have an immediate need for income.

Company or personal contributions

Registered pension schemes can accept contributions from you personally or direct from your company on your behalf. The latter are slightly more tax efficient (see the next step).

Tip. If your pension plan does not accept employer contributions, it is typically easy to make a change to allow them. Ask them to speak to their financial advisor or the pension company.

Tip. Pension contributions have the advantage that your company can pay them even where it has not made profits. This is not allowed with dividends.

How much can you pay?

While your company can pay substantial amounts into a registered pension scheme, At one point it becomes less tax efficient than taking equivalent dividends. The optimum amount is that which brings your total pension contributions (personal and company) up to £40,000 in a year (the area allowance)

Tip. If annual allowances have not been fully used in the last three tax years, the company can use them to make a larger pension contribution in 2021/22. For example, if your total pension contributions were £8 000 for each of 2018/19 2019/20 and 2020/21, the shortfall of 32000 per year, £96,000 in total, is added to the annual allowance for 2021/22

Tax savings - pension v dividends

The table below shows the net income you would receive per £1,000 taken as a dividend or paid by the company to your pension fund and later taken as pension income. The pension income is a winner whether you are a basic or higher rate taxpayer. You will have to wait until you are 55 to get the pension money and so there is a trade-off between immediate need for income and long- term tax efficiency.

  Dividend (£) Pensions (£)

Amount of gross income 1,000 1,000

Add corporation tax relief* - 190

Pension tax free amount 25% 0 250

Taxable amount 1,000 940

Less basic rate tax (7.5%/20%) 75 164

Net income 925 1,026

Less higher rate tax(32.5%/40%) 325 362

Net income 675 828

*Tax relief received by company on pension contributions and taken as a dividend.

If you don’t want to take all the profit from your company, extracting it as an employer pension contribution is a more tax-efficient alternative. In the long run it could save tax of almost £40 per £1,000 of income if you are a basic rate taxpayer or £150 per £1,000 if you pay higher rate tax.