As a business owner, one of the most tax-efficient ways to manage your income is by contributing to your pension via your limited company. While many entrepreneurs focus on salary and dividends to reduce their tax liabilities, contributing to a pension can be an even better option.
The Tax-Efficient Approach
For many entrepreneurs, the common approach is to take a salary of around £11,980 annually, which keeps the income below the National Insurance primary threshold, allowing you to avoid paying National Insurance contributions. This salary also falls under the £12,570 personal allowance, meaning it won’t be taxed. The remaining income is typically taken as dividends, which are taxed at a reduced rate of 8.75% for basic rate taxpayers and 33.75% for higher rate taxpayers. Additionally, there’s a £2,000 dividend allowance to further reduce the tax burden.
However, many business owners mistakenly believe that contributing to a pension is unnecessary, simply because their salary falls under the personal allowance. This is a misunderstanding—pensions are an excellent tool for extracting money from your business in a tax-efficient manner.
Understanding the Annual Pension Allowance
The first concept to understand is the annual pension allowance, which is currently set at £40,000. If your earnings are under this amount, you can contribute up to the total of your UK earnings to your pension. However, if you exceed this limit, you may face a tax charge to reclaim the tax relief you’ve already received.
Many entrepreneurs believe they can only contribute an amount equal to their salary, which is often £11,980. But dividends are not considered “relevant UK earnings” for pension contributions, so they do not limit your contribution.
Using Your Limited Company for Pension Contributions
When you have a limited company, you can make contributions to your pension as an employer, which allows you to use pre-tax company profits. This means you can contribute up to the £40,000 limit without any personal tax implications.
The benefits of making employer pension contributions are significant. For instance, if you’re a higher-rate taxpayer, £1,000 taken from your company’s profits as dividends would only result in a net payment of £536.63 after taxes. However, if you contribute that same £1,000 directly into your pension, the entire £1,000 is paid into the fund, effectively giving you an 86% return on your money by recovering both income and corporation tax. Over time, consistently making the maximum pension contribution can add substantial wealth to your retirement fund.
Corporation Tax Savings and the ‘Wholly and Exclusively’ Test
To make these contributions, the payments must be deemed “wholly and exclusively” for the business. This generally means the contributions should be commercially reasonable for the work you’re doing for your company. If you also make contributions for other employees, the contributions you make on your own behalf should not exceed what’s deemed reasonable for their roles.
Pension contributions can also be classified as a business expense, meaning they are deducted from your company’s profits before tax. This offers a double advantage: not only do you receive tax relief on the pension contributions, but you also save on corporation tax, which is currently at 19%.
Inheritance Tax Benefits
Another important benefit of pension contributions is their potential inheritance tax advantages. Many business owners rely on selling their business to fund their retirement, but this strategy may not always work out. Even if you do sell your business, having a well-established pension fund can offer considerable value.
By building up your pension, you can create a valuable asset that is free from inheritance tax, effectively allowing you to pass the funds to your beneficiaries without the usual tax burdens. This means that, should you sell your business, your pension can serve as a legacy for your family, ensuring they are well cared for.
Why You Should Contribute to Your Pension Through Your Limited Company
The real question isn’t why you should contribute to your pension through your company, but rather, why wouldn’t you? The tax advantages, savings, and potential for wealth-building are too significant to overlook. If you’re not taking advantage of this opportunity, it might be time to reconsider your approach and seek expert advice.
