How business owners can boost tax efficiency with pension contributions

Contributing towards a pension is not just about saving for your retirement. Thanks to the tax reliefs provided when you place money into a pension, it’s also one of the most tax-efficient ways to build wealth.

This is also true for business owners. According to FTAdviser, in 2020/21, the amount paid into personal pensions by the self-employed increased by more than 17% on the previous year.

While this is good news, the article goes on to explain that the level of contributions by the self-employed still may not be at an adequate level. It makes an interesting point, when you consider pension contributions can be an effective way to increase tax efficiency for sole traders and owners of limited companies.

Read on to discover how your clients who are business owners may be able to reduce their and the company’s tax liability by the use of pension contributions.

A sole trader can enjoy significant tax benefits

If your client is a sole trader or partner, they will receive tax relief at their marginal rate on pension contributions. As such, if they’re a basic-rate taxpayer they will only pay £80 for every £100 contributed to their pension.

If they are a higher-rate taxpayer it will cost just £60, and if they are an additional-rate taxpayer they may only pay £55 in every £100. While clients in these tax brackets receive relief on the full 40% or 45% of tax that they pay, HM Revenue & Customs (HMRC) pay back the basic-rate of 20% automatically to the pension provider.

This means that they will need to claim the additional 20% or 25% via self-assessment, something a financial planner could help your client with.

While your client can contribute as much money as they like to their pension, the amount that receives tax relief is limited to their Annual Allowance. In 2022/23, this is typically the amount they earn or £40,000 a year, whichever is lower. 

If your client is a high earner, their Annual Allowance may drop to just £4,000. That said, in certain circumstances they may be able to contribute more than their Annual Allowance and still receive tax relief using “carry forward”. 

This allows your client to use any unused amount from the previous three years’ Annual Allowance, which means they may be able to contribute up to £160,000 (2022/23) into their pension and still receive tax relief.

Contributions by a limited company may be a “business expense”

If your client owns a limited company, the business could make contributions to their pension scheme, as opposed to it coming from their salary or personal funds. A benefit of this is that contributions could be treated as a business expense and offset against the firm’s profits, which could help reduce its exposure to Corporation Tax. 

In 2022/23 Corporation Tax is typically charged at 19%, so using pension contributions to reduce this could help reduce the business’s liability to HMRC.

Additionally, using this method means that the business will not have to pay National Insurance contributions (NICs) on the money placed into a pension. Instead, your client might want to consider adding the amount that would have been paid in NICs to the pension to help boost its value more quickly. 

While the salary aspect of the Annual Allowance doesn’t apply, contributions that receive tax relief will still be limited to £40,000 a year. If your client wants to use this method, they will have to show HMRC that the contributions are “wholly and exclusively” for business purposes. 

This means that they will have to demonstrate that the contributions are commercially reasonable for the work they do and that they are in line with those made for other employees with similar responsibilities.

A director can make contributions out of their own funds

As a director of a limited company, your client has the option to make contributions to their pension from their earnings. If this is something they are considering, they may need to think carefully about their Annual Allowance.

This is because many directors pay themselves a salary of up to the Personal Allowance (£12,570 in 2022/23) and then use dividends to boost their annual income. As there is no Income Tax liability for salaries below the Personal Allowance, and Dividend Tax is typically charged at a lower rate than Income Tax, it can be more tax-efficient to draw a salary in this way.

If your client does this, they will need to remember though that dividends cannot be used to make pension contributions. This will typically mean that their Annual Allowance will be set at their salary, which is likely to be low. 

As a result, larger pension contributions made from their salary will probably not receive tax relief. While your client may be able to increase their salary and reduce the amount of dividends they take in order to increase their Annual Allowance, this could expose them to a greater Income Tax liability. 

Get in touch 

As an accountant or a legal professional, it’s likely you will have clients who are business owners. If you or your client would like to discuss how we could help make them or their company more tax-efficient through the use of pension contributions, we would be happy to talk.

Simply contact us at hello@ardentuk.com or call 01904 655 330. As an award-winning financial advice company that was a 2022 VouchedFor Top Rated firm, you can be sure that your clients will receive excellent advice and a high quality service.

Please note

This blog is for general information only and does not constitute advice. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change. 

The information is aimed at retail clients only.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.

Get in touch

By talking about your current situation and listening to your aims, we create a personalised plan that will put you on a path to achieving your aspirations.

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