The tricky business of profit extraction – Dividends & Pensions

The dividend changes will strengthen the case for business owners using pension contributions to extract profits from their company tax efficiently. Many directors of small and medium sized companies may be facing an increased tax bill next year as a result of how dividends will be taxed. And a pension contribution could be the best way of cutting their tax bill, while still receiving the same level of benefit.

Shareholding directors of private companies have long been accepting of the idea that dividends are preferable than salary or bonus as a way of extracting profits from their business. But from April, the advantage that dividends held will be narrowed for many high earning directors. And as the salary v dividend gap closes, it reinforces the case for directors taking at least part of their benefits as a pension contribution where possible.

The changes

From 6 April 2016, dividends received will be taxed differently. This won’t affect the amount actually paid out by the company – this remains as profits after corporation tax at 20% – but there will be a change to how that dividend is taxed in the hands of a shareholder.

The 10% notional tax credit will be abolished, and replaced by a £5,000 annual dividend allowance. Dividends received within this allowance will be tax free, although will still count as income in the tax band. Dividends above the allowance will be taxed at higher rates than this year, as follows:

15/16 16/17
Non taxpayers 0% 0%
Basic rate payers 0% 7.5%
Higher rate payers 25% * 32.5%
Additional rate payers 30.56%* 38.1%

 

* effective rate of tax on dividend received before grossing-up, e.g. tax due for additional rate taxpayer on £100 of gross dividend at 37.5% is £37.50. After notional tax credit of £10 is taken off, they will have an extra £27.50 to pay. Which is the same as 30.56% on the net dividend of £90.

The impact

Many shareholding directors take a significant part of their remuneration in the form of dividends, benefiting from the savings made in National Insurance, particularly the 13.8% assessed on employers. Currently this will give them more spendable income than paying themselves in salary and bonuses only.

How will this strategy stack-up next year following the changes?

Once dividends exceed a certain level, they will be worse off under the new rules. For an individual receiving dividends in the higher rate band, that tipping point will be as low as £21,600.

Critically, this will still be better than paying themselves a salary. So it’s perhaps unlikely that many will make the switch from dividends to salary immediately.

BUT, is there better value to be had by taking their benefits as an employer pension contribution?

Salary or dividend… or pension contribution?

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.

Let’s assume that a company has earmarked £40k of gross profit for one of its shareholding directors, who is normally a higher rate taxpayer.

The merits of each option are shown in the following table:

Salary Dividend (16/17 rules) Dividend 1(15/16 rules) Pension taken @ 0% 2 Pension taken @ 20% 2 Pension taken @ 40% 2
Gross Profit 40,000 40,000 40,000 40,000 40,000 40,000
Pension contribution 0 0 0 40,000 40,000 40,000
Corporation tax @20% 0 8,000 8,000 0 0 0
Dividend 0 32,000 32,000 0 0 0
Employer NI 3 4,850 0 0 0 0 0
Gross bonus 35,150 0 0 0 0 0
Director’s NI 3 (703) 0 0 0 0 0
Income tax (14,060) (10,400)
(8,775) 4
(8,000) 0 (6,000) (12,000)
Net benefit to Director 20,387 21,600
23,225 4
24,000 40,000 34,000 28,000
Effective rate of tax (on £40k gross profit) 49% 46%
42% 4
40% 0% 15% 30%

 

1 Column shows net benefit from dividend if taxed under current tax rules.
2 Pension benefits are taken within the Lifetime Allowance.
3 Assumes NI rates for 2015/16 (13.8% employer, 2% employee).
4 Benefit if full £5k annual dividend allowance is available

Clearly, the net benefit to the director of taking dividend won’t be quite as much next year as it would be for the current year – even if £5,000 of the dividend is covered by the new annual dividend allowance.

But it’s still better than taking as salary – thanks to the National Insurance savings (employer and employee NI is not paid on dividend distributions).

Pensions too mean NI is avoided and also a deduction for corporation tax. And when benefits are taken, 25% can be received tax free with the balance taxable as income.

The amount of benefits taken under flexi-access drawdown can be controlled. This opens the door to efficient retirement income planning, providing the opportunity to maximise the use of annual tax allowances with their pension and other investment wrappers, and potentially reducing the tax on drawdown income to 20% or even 0%.

Other considerations when choosing the pension route

It goes without saying that, when considering a strategy, each individual’s own circumstances must be taken into account. What may be right for one person may not be the best fit for another. And it’s not just the best tax option that can influence choice.

As far as pensions are concerned, the following points may also need to be taken into account.

  • LTA – Those who already have significant pension funding and who have pension funds in excess of the Lifetime Allowance, or could exceed it with future growth, will need to take account of the LTA tax charge before deciding on their strategy for extracting profits.
  • MPAA – Those who do wish to continue funding up to the pension annual allowance of £40k pa will need to ensure that they don’t access any ‘income’ under flexible access drawdown, otherwise their money purchase annual allowance will drop to £10k for good and they’ll lose any opportunity for carrying forward unused allowance from earlier years.
  • High earners – Taking benefits as a pension contribution instead of salary or dividends could mean that ‘high earners’ stay below the ‘adjusted income’ limit of £150k, and so avoid the annual allowance being tapered (potentially dropping to only £10k).
Why wait?

The tax benefits for making a pension contribution haven’t changed – it’s just that the merits of the taking dividends will diminish. So there’s no reason to wait until next April to make pension funding.

Paying before April could hold some advantages;

  • The main rate of Corporation tax is set to fall by 1% in April. So making a contribution in the current accounting period could benefit from higher corporation tax relief.
  • High earning clients who will face a reduction in their annual allowance to £10,000 from next April may want to maximise their contributions now.
  • And remember, the 2015/16 PIP changes could mean that some individuals have additional annual allowance available before April.

 

 

 

Source: Standard Life