OCL: Employer pension contributions v dividends?

Dividends are usually the most tax-efficient way to extract profit from your company. However, can pension contributions ever be a better option?

Tax and profit extraction
Since April 2016 the government has introduced a number of measures 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, if you don’t have an immediate need for income you should consider reducing dividends in favour of pension contributions for longer term tax efficiency.

Company or personal contributions
Registered pension schemes can accept contributions from you personally or direct from your company on your behalf. The latter, known as employer contributions, are slightly more tax efficient.

If your pension plan doesn’t accept employer contributions, it’s usually easy to make a change to allow them. Speak to your financial advisor or the pension company.

Pension contributions have the advantage that your company can pay them even where it hasn’t made profits. This isn’t allowed with dividends.

How much can you pay?
While your company can pay substantial amounts into a registered pension scheme, for you there is a point at which they become less tax efficient than taking equivalent dividends. The optimum amount is that which brings your total pension contributions (personal and company) up to £60,000 (£40,000 for 2022/23 and earlier years) in a year. This is called the annual allowance.

If annual allowances haven’t been fully used in the last three tax years, your company can use them to make a larger pension contribution in 2024/25. For example, if your total pension contributions were £15,000 for each of 2021/22, 2022/23 and 2023/24 the shortfall of £25,000 for the first two years and £35,000 for the latter (£85,000 in total), is added to your annual allowance for 2024/25.

Tax savings – pension v dividends
When looking at the net income you would receive per £1,000 taken as a dividend vs paid by your company to your pension fund and later taken as pension income, the pension income is a winner whether you’re a basic or higher rate taxpayer. You’ll have to wait until you’re 55 to get the pension money and so there’s a trade-off between immediate need for income and long-term tax efficiency.

For more information contact us – call Tristan Wilcox-Jones, Samantha Gillham or Lucas Knight on 01225 445507 to arrange a no-obligation meeting.