We’re often asked how best to extract profits from a business. Whilst additional options apply when retirement is being considered, for an ongoing business there are three main options; salary/bonus; dividends; pension contributions.
Whilst the best option will always depend on personal preference the interaction of the 4 main taxes needs to be considered. Additional considerations apply for pension allowances.
Salary and pension contributions should be classed as allowable business expenses. They will reduce the amount of corporation tax payable. Dividends are not a business expense and will be subject to corporation tax and hence are paid from profits after corporation tax of 19% has been deducted.
National Insurance (NI) contributions are paid on an employee’s salary or bonus. The rates are 13.8% employer NI; 12% employee NI on salary below the upper earnings limit and a further 2% above the limit.
Salary will be subject to the client’s marginal rates of income tax. Should you be earning at or around £100,000 then paying extra salary could be much less desirable as your personal allowance is tapered away for gross income above £100,000.
The same is true of dividends although the client may also have access to the dividend allowance of £2,000. Higher rate tax for dividends is at 32.5%
Pension contributions are not taxed immediately. They will eventually be subject to income tax at your marginal rate but 25% should be paid tax-free. In retirement, it may be the case that the pension income is taxed at a lower rate. Also bear in mind that taking flexible income from a pension limits future pension contributions to just £4,000 pa.
Inheritance Tax (IHT)
Payments made to pensions should remain outside your estate for IHT purposes. If you already have an IHT issue and don’t need the income, taking dividends or salary just to invest will only add to the issue.
Annual Allowance (AA) and Lifetime Allowance (LTA)
The effect of both allowances always needs to be considered when adding to a pension but should not necessarily prevent a contribution being paid.
There’s no point extracting money from your business but then being unable to spend it if you need to do so. You can’t currently access pension funds if under the age of 55. This takes us back to personal need and why even if the numbers favour one route it needs to be right for you.
Usually, the best route to take will be a combination of all three elements, salary, dividend and pension contribution designed to suit your personal circumstances. You should always take advice before taking action. This article is for guidance only and should not be taken as personal advice.
The example below assumes a company with £40,000 to distribute. The individual receiving the payment already has income above the higher rate band and has used the dividend allowance, but this payment will fall below £100,000 total taxable income.
|Cost to company||£40,000||£40,000||£40,000|
|Immediate Income tax||£14,060||£10,530||–|
|Employee National Insurance||£703||–||–|
|Income tax if drawn from pension *||£12,000|
*assuming income tax rates remain the same, 25% tax-free cash is taken and residual taxed at 40%