Tax Efficient Pension Contributions - A Summary for Owner Managed Businesses

As the owner/director of a limited company, there are tax advantages one should be aware of when making contributions into an eligible pension fund like a SIPP.

Tax efficient contributions can be made through a limited company or personally from drawings taken.

In this article we will compare and contrast the tax advantages available from the different methods.

Making contributions through a company

As the owner/director of a limited company, one can claim corporation tax relief on eligible pension contributions.

The advantages of making contributions in this way are that:

• Corporation tax relief is given on the amount paid into the pension

• Contributions made do not attract any employer’s NI or personal tax liabilities

Making contributions personally

Contributions can be made into an eligible pension using drawings from the company (e.g., salary).

Employer’s NI and personal tax liabilities will arise in the normal way as they do when drawing down from a company.

When paying into an approved pension fund, a top up is received from the taxman at 20% if one is a basic rate taxpayer, 40% if one is a higher rate taxpayer and 45% for an additional rate taxpayer.

By way of example, consider the different tax relief scenarios in the table below.

Depending on the level of contribution made and whether one is a basic rate or higher rate taxpayer, the level of tax relief varies.

There are limits to the level of pension contribution that can be made each year into one’s chosen fund:

• A person can pay up to the lower of their annual earnings or £40,000 a year into a chosen pension

• Any unused annual allowance can be carried forward for 3 years

• There is a lifetime limit currently set at £1.073m which limits the total level of pension contributions which can be made while attracting tax relief 

Working through the options with some numbers:

Note: Below is a general guide – for guidance specific on your circumstances please seek the advice of an Independent Financial Advisor (IFA)

Tony is a self-employed owner director of Tony’s Experienced Light Fittings Ltd – a specialist electrical subcontractor operating in the UK construction sector.

Tony wishes to make a £20,000 contribution into his pension scheme. 

Is it better for the company to contribute directly or should Tony make the contribution out of his net pay? 

1.     Company contribution

Tony’s Experienced Light Fittings Ltd pays £20,000 directly into Tony's scheme. 

The corporation tax bill paid by the company is reduced by £3,800 as a result of the £20,000 contribution (that is – tax relief at 19%)

The net cost of the contribution is therefore £16,200.

2.     Tony makes the contribution from his earnings as a basic rate taxpayer

The company pays Tony a salary of £23,530. Employer's National Insurance of £3,247 is due on this salary amount so the total salary bill to the company is £26,777. 

Tony’s total income for the tax year concerned puts his earnings from the company into the basic rate tax bracket (i.e., 20%).

i) Impact on the company of Tony’s salary:

Corporation tax relief of £5,088 is received on the salary bill (i.e., 19% of £26,777).

The net cost to the company is therefore £21,689.

ii) Impact to Tony personally:

Tony pays £7,530 in tax in total (20% income tax and employee’s national insurance of 12%), leaving £16,000 as net pay.

Tony contributes his entire net pay from the company of £16,000 into a pension. 

The pension provider then claims £4,000 from the government so the gross contribution made is £20,000.

Note - £4,000 is claimed back as this represents 20% of £20,000. If Tony was a higher rate taxpayer, £4,000 would still be claimed back by the pension provider, but Tony would also be able to claim back a further £4,000 relief through the self-assessment process such that a 40% top up (i.e., £8,000 in total) is effectively received.

Which outcome is better?

Making the pension contribution through the company is the least cost option. Under this scenario, to put £20,000 into Tony’s pension, the net cost is only £16,200.

The net cost of placing £20,000 into the pension personally and via the government top up, is £21,689. This is effectively £5,489 more than paying into the pension directly from the company.

 Conclusion

Paying into an approved pension can be a tax efficient way of releasing equity for an owner/director of a limited company.

One can usually withdraw from a private pension plan from the age of 55 onwards, and 25% can typically be taken tax free.

It can also mean that income is effectively pushed into the future at which point in time one may have a lower income, and therefore get taxed at the basic rate.

However, one should consider that funds are locked away until retirement. This is an especially important consideration the further away from retirement one is.