Pension v dividends – the tricky business of profit extraction part-2
Being part of a truly independent financial Chartered National firm Fairstone Financial Management. Chase Financial Management has access to many valuable planning resource, and from all of the providers that we might deal with, such as this article below from Standard Life technical department, which clearly lays out the three main ways in which a business owner may extract the profits that they make from their businesses.
Tapered Annual Allowance
Many high earning business owners could see their annual allowance (AA) tapered down to just £10,000. However, by reducing what they take in salary or dividends and paying themselves a larger pension contribution instead could mean they retain their full £40,000 AA. This is because contributions of this type should not be viewed as salary sacrifice, and therefore will not count towards ‘threshold income’.
For example – Amy, 55, runs her own company and pays herself dividends of £150,000 for the 2017/18 tax year. She has no other income. She makes employer contributions of £20,000 into her SIPP.
The two tests which determine whether the AA is tapered are:
- Adjusted income – if this is more than £150,000 the AA is reduced by £1 for every £2 over the limit, subject to a minimum allowance of £10,000
- Threshold income – if this is less than £110,000, there will be no tapering and the full £40,000 allowance will be available.
Her ‘adjusted income‘ is £170,000 (income + employer pension contribution). As this is £20,000 above the £150,000 cap, it would normally cut her AA by £10,000 (to £30,000). This means any opportunity to increase her funding for this year, or in the future using carry forward from 2016/17, would be limited to £10,000.
However, if she cuts her dividends by just over £40,000 her ‘threshold income‘ (total income without employer contributions) would be below £110,000, preserving her full £40,000 allowance.
She could pay the corresponding amount (which would actually be £49,383 – more than the £40,000 dividend which is net of corporation tax) into her pension as an employer contribution using carry forward of unused AA from previous tax years. This would not affect her AA for 2017/18 because only employer contributions as part of new salary sacrifice arrangement are used to determine threshold income. A shareholder director making an employer pension contribution rather paying salary or dividend is not salary sacrifice.
As Amy is over 55, she has unrestricted access to the funds in her SIPP. If she made use of the new income flexibilities she would trigger the money purchase annual allowance (MPAA) cutting her future funding to £4,000 a year., with no opportunity to use carry forward. However, if she only touches her tax-free cash and takes no income she would retain her full AA.
With the tax year end approaching, there are several reasons why your clients may benefit from making an employer pension contribution now:
- Avoid AA taper – to ensure that this year’s annual allowance is not tapered. Remember bonus and dividends count towards the £110,000 threshold income, but employer contributions normally don’t.
- Use full pension allowance – to use up any unused annual allowance from 2014/15 which would otherwise be lost.
- Deliver more tax efficient income – so that profits which may otherwise be taken as bonus or dividend do not boost income to the point where the personal allowance is lost, or child benefit taxed.
- Get in shape for retirement – to maximise tax efficient funding if they shortly plan to reduce working hours pre-retirement and start to draw pension income, at which point any future funding will be restricted to the money purchase annual allowance of £4,000 and unused carry forward allowances lost
In addition to this, there will be many companies with a financial year in line with the tax year e.g. where the company business year ends on 31st March. These companies will not be able to confirm any final dividend until after this date. If these dividends are subsequently paid in 2018/19, they may use up next year’s lower dividend allowance before the new company year has even started.
The content of this document should not be deemed to constitute the provision of financial, investment or other profession advice in any way.
The value of investments and the income from them can go down as well as up and investors may not recover the amount of their original investment. Past performance is not a guide to future performance.
Fairstone Financial Management Limited does not offer tax advice; the tax treatment of investments depends on each investor’s individual circumstances and is subject to changes in tax legislation.
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