Those in control of how to extract money from their business broadly have three main options. These are to take out the money as salary, dividends, or by making employer pension contributions.
When a company director wants to extract profits, they might be advised to pay themselves a minimal salary up to a certain limit (Usually the secondary earnings limit of £175 per week) and then take the rest in dividends. However, dividend and corporation tax rate changes have made this option less attractive. Once immediate income needs are met, it may be wise to consider making pension contributions.
If you receive further dividends, they will be subject to both corporation tax at 25% and higher dividend tax rates. The higher rates are 8.75%, 33.75%, and 39.35%. If you make a pension contribution, you won’t have to pay tax on it right away. As long as it meets the usual “wholly and exclusively” rules, it will be treated as a business expense. When you receive your pension, there will be tax, but 25% is usually tax-free. The remainder will be subject to income tax at your marginal tax rates. If you retire and your rates are lower, you may pay less tax.
Examples – tax year 2023/24
Consider a shareholding director with £10,000 of profits to consider, assuming they are and remain a basic rate taxpayer and the dividend allowance has already been used. For simplicity, the examples have assumed no growth on investment of either the pension or extracted funds.
Basic rate taxpayer |
Dividend |
Pension |
Cost to company |
£10,000.00 |
£10,000.00 |
Corporation tax @ 25% |
£2,500.00 |
– |
Amount paid |
£7,500.00 |
£10,000.00 |
Dividend tax @ 8.75% |
£656.25 |
|
Tax on pension if withdrawn* |
£1,500.00 |
|
Net benefit |
£6,843.75 |
£8,500.00 |
*Assuming income tax rates remain the same, 25% tax-free cash is taken, and the residual is taxed at the basic rate (20%).
Higher rate taxpayer |
Dividend |
Pension |
Cost to company |
£10,000.00 |
£10,000.00 |
Corporation tax @ 25% |
£2,500.00 |
– |
Amount paid |
£7,500.00 |
£10,000.00 |
Dividend tax @ 33.75% |
£2,733.75 |
|
Tax on pension if withdrawn* |
|
£3,000.00 |
Net benefit |
£4,968.75 |
£7,000.00 |
*Assuming income tax rates remain the same, 25% tax-free cash is taken, and the residual is taxed at a higher rate (40%).
The pension has a clear advantage for both basic and higher-rate taxpayers. Where someone is a higher-rate taxpayer now but becomes a basic-rate taxpayer in retirement, the benefits of the pension contribution are even greater. They could receive £4,968.75 as a dividend or an after-tax pension payment of £8,500 in retirement. 71% more money.
Pension contributions for business owners are one of the best tax-planning strategies available. The increase of the pension annual allowance (the amount individuals can pay into pensions each tax year) from £40,000 each tax year to £60,000 has only increased the potential tax savings.
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