Excess Profit: The Conundrum of Pension Contribution v Dividend v Bonus

It’s that time again! We are nearing the end of the current tax year 2018/19 and the way business owners decide to take excess profits from their Small Medium Enterprises (SMEs) can have an eclectic result. For owners who have taken their required salary and dividends for the tax year, a question begs - what to do with the remaining profit within the company?

The two main ways to distribute such profits are by taking a bonus (taxed as salary) or taking additional dividends. As an example of this, a higher rate taxpayer who wishes to take out profits will incur the below tax charges:
 

  Bonus Dividend*
Company profit £40,000 £40,000
Corporation tax 19% £0.00 (£7,600)
Employer NI 13.8% (£4,850) £0.00
Value to director £35,150 £32,400
Director's NI 2% (£703) £0.00
Director's income tax 40%/32.5% (£14,060) (£10,530)
Net benefit to director £20,387 £21,870

*Assumes that the director has already used £2,000 dividend allowance.

 

As you can see from above taking profits via dividends is slightly more tax efficient than taking a bonus. However, with taking profits in this manner comes two further potential tax implications:

  • Loss of Personal Allowance: For every £2 earned over £100,000, they will lose £1 of their £11,850 personal allowance. As such, if they combine existing salary, dividends and take excess profit by the above two options, they would lose their full personal allowance if the amount went over £123,700.
  • Tapered Annual Allowance: If an owner’s threshold income meets £110,000 and their adjusted income meets £150,000, their annual allowance will reduce by £1 for every £2 over £150,000 up to £210,000, leading to maximum reduction of £30,000 This leaves them with a remaining annual allowance of £10,000.

The third option is a lump-sum employer pension contribution. The benefit to an owner is that they are classed as both the employer and the employee of their company, therefore the profits could be used to make an employer pension contribution. Using the £40,000 example, this enables them to benefit from the full amount without any initial tax or national insurance deductions. When in the pension tax-wrapper, the £40,000 will not be subject to any income tax, dividend tax or capital gains tax. Only at the point they start to take income from the pension (preferably as a basic rate taxpayer) would they then pay income tax on this. If we take the below table into consideration (as we did for the bonus and dividend payment) you can see the difference this makes:
 

  Employer Pension Contribution
Company profit £40,000
Corporation tax 19% £0.00
Employer NI 13.8% £0.00
Value to director £40,000
Director's NI 2% £0.00
Director's income tax 40%/32.5% £0.00
Net benefit to director £40,000

 

Other reasons that an employer pension contribution is a preferable solution for excess profits are:

  • Your future: You can establish or make further contributions to your pension pot in order to grow your retirement fund before taking pension income and being affected by the Money Purchase Annual Allowance at £4,000 per tax year.
  • Tax efficiency: Employer contributions will be subject to corporation tax relief and do not boost your threshold income. This would happen if you took an additional bonus or dividend therefore potentially mitigating a loss of personal allowance.
  • Mitigation of AA Tapering: Employer contributions do not count towards threshold income of £110,000, therefore potentially saving up to £30,000 of annual allowance.
  • Carry Forward 15/16 AA: This is the last tax year to take advantage of annual allowance from 15/16 to carry forward to the current tax year.
  • Succession: Normally pensions do not make up part of an estate for inheritance tax purposes.

**The above is a simplified summary and there are other taxes to consider such as the Lifetime and Annual Allowance Charge, if you are interested please contact our Wealth Management Team

For more information or to discuss your requirements, please contact us.

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