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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.

When the owners of SME companies come to choose how they take their profits, the argument in favour of pension contributions has been gaining momentum over the last 2 years.

While dividends may still be king, changes in how they are taxed are driving more directors who don’t need the income for day to day living to extract profits using employer pension contributions instead. The impending drop in the annual dividend allowance from £5,000 to just £2,000 from April 2018 means that higher rate taxpayers could face a further tax bill of £975, increasing the focus on the pension alternative.

Tax efficient extraction

Despite the dividend option becoming more expensive, it still remains a better option than salary for most directors withdrawing profits significantly above the annual dividend allowance. For a higher rate taxpayer, the combined effect of corporation tax at 19% and dividend tax of 32.5% will still yield a better outcome than paying it out as salary, which needs to account for income tax at 40% plus employer NI of 13.8% and employee NI of 2%.

However, a pension contribution remains the most tax efficient way of extracting profits from a business. An employer pension contribution means there’s no employer or employee NI liability – just like dividends. But it’s usually an allowable deduction for corporation tax – like salary.

And of course, under the new pension freedoms, those directors who are over 55 will be able to access it as easily as salary or dividend. With 25% of the pension fund available tax free, it can be very tax efficient – especially if the income from the balance can be taken within the basic rate (but remember, by doing so, the MPAA will be triggered, restricting future funding opportunities).

In reality, many business owners will pay themselves a small salary, typically around £8,000 a year – at this level, no employer or employee NI is due and credits will be earned towards the State pension. They will then take the rest of their annual income needs in the form of dividend, as this route is more tax efficient than taking more salary. But what about the profits they have earned in excess of their day to day living needs?

The table below compares the net benefit ultimately derived from £40,000 of gross profits to a higher rate taxpaying shareholding director this year.

  Bonus Dividend* Pension
Company profit £40,000 £40,000 £40,000
Corporation tax 19% £0 £7,600 £0
Employer NI £4,850 £0 £0
Value to director £35,150 £32,400 £40,000
Director’s NI (£703) £0 £0
Director’s income tax (£14,060) (£10,530) £0
Net benefit to director £20,387 £21,870 £40,000

* Assumes full £5,000 annual dividend allowance has already been used.

Clearly, the dividend route provides more spendable income than the bonus alternative, but if the director does not need this income, the value in their pension pot is almost doubled.

When they take money from their pension to support their income needs, the figures still compare favourably. Assuming the £40,000 fund is taken when the director is a basic rate taxpayer, net spendable income will be £34,000*. If taken as a higher rate taxpayer, net spendable income will be £28,000*. That is 55% and 28% more than the dividend option.

From a family protection point of view, if not withdrawn for income purposes, the full £40,000 could be paid to the director’s loved one’s tax free should death occur before 75, or otherwise at the beneficiaries own marginal rate of income tax.

* Assumes pension income is taxed after taking 25% tax free cash, and there is no Lifetime Allowance charge. Growth has been ignored.

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.

For further information or advice, then please feel free to contact Mark Dickens or Andrew Wilkinson at Chase on 01452 560470 or email mark@chasefm.biz or andy@chasefm.biz