Pension v Dividends
When the owners of small and medium sized 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 do not 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 £5,000.00 to just £2,000.00 from April 2018 means that higher rate tax payers could face a further tax bill of £975.00. This is increasing the focus on the pension alternative.
Tax Efficient Extraction
Despite the dividend options becoming more expensive, it still remains a better option than salary for most directors who are 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. As salary would need to account for income tax at 40% plus employer National Insurance of 13.8% and also employee National Insurance 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 National Insurance 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 the age of 55 will be able to access it as easily as they would a 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 in the future.
In reality, many business owners will pay themselves a small salary, typically around £8,000.00 a year. At this level, no employer or employee National Insurance 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 dividends, 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?
Time is always tight if you’re a business owner, however, taking just a small amount of time to consider the best way of extracting profits from your business may well prove very beneficial.
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