Tax benefits of personal pensions for company directors
There are several tax benefits of personal pensions for company directors, on both personal and company pension contributions. Contributions into a personal pension allow directors to withdraw money from their limited company tax-efficiently.
UK individuals can contribute up to £60,000 a year to a personal pension and receive tax relief. The annual allowance of £60,000 includes company/employer pension contributions, personal contributions plus tax relief from the government. As an illustration, if your company contributes £20,000 to a pension, you will be able to contribute a maximum of £32,000 on which you will receive tax relief of £8,000, taking the total contributions to £60,000. Your income, excluding dividends must equal or exceed your contributions to be eligible for tax relief. Unused pension allowances from the previous three years can be carried forward.
Tax efficient contributions
Making both personal and company contributions into a pension is a highly tax-efficient way of withdrawing funds from a limited company. Company pension contributions are a tax-deductible expense, reducing the amount of corporation tax payable.
Individuals can make personal pension contributions up to the amount of their annual income and receive tax relief on these contributions. Dividends are not considered income for pension tax relief purposes. The amount of tax relief an individual receives is based on their income tax band. Individuals paying tax at the basic rate of tax receive 20% tax relief on their pension contributions. Higher-rate taxpayers will receive 40% tax relief and an increase in their basic rate tax band threshold. Company contributions do not receive tax relief.
Dividend allowance
All UK individuals have a tax free dividend allowance of £1,000 for the tax year 2023/24. This allows individuals to earn up to £1,000 in dividends tax free. From the tax year 2024/25 the allowance decreases to £500.
Example
Let’s assume Fred, a director of a limited company, pays himself a salary of £20,000 per year and withdraws dividends of £40,000 from the company. Fred makes contributions of £10,000 to his personal pension. The company also contributes £20,000 to Fred’s pension.
The company contribution of £20,000 is an allowable expense and is deductible from the net profit of the company. This reduces the corporation tax payable by between £3,800 and £5,000, depending on the company’s marginal corporation tax rate.
The director’s basic rate tax band threshold is increased by the amount of the personal contributions of £10,000. Fred’s basic rate tax band increases from £50,270 to £60,270.
| Income | Amount | Tax – with pension contributions | Tax – without pension contributions |
|---|---|---|---|
| Salary | £20,000 | £1,486 | £1,486 |
| Dividends tax free | £1,000 | nil | nil |
| Dividends @ 8.75% | £29,270 | £2,561 | £2,561 |
| Dividends @ 8.75% | £9,730 | £852 | |
| Dividends @ 33.75% | £9,730 | nil | £3,284 |
| Total dividend tax | £3,413 | £5,845 | |
| Pension tax relief | £2,500 | nil | |
| Saving in corporation tax (assume 19%) | £3,800 | nil |
Tax without pension contributions
As illustrated in the above example, if Fred doesn’t make any personal pension contributions, £9,730 of Fred’s income falls into the higher tax band of 40%. The basic rate tax band threshold is £50,270 and Fred’s total income is £60,000. Dividends falling within the higher tax band are subject to tax at 33.75%, which is £3,283 on dividends of £9,730.
Tax with personal pension contributions
If Fred decides to make a personal contribution to his pension, his basic rate tax threshold is increased by the amount he contributes to his pension. If he contributes £10,000 to his pension, his basic rate tax band increases from £50,270 to £60,270. This results in all of his dividends being taxed at the basic dividend tax rate of 8.75%. This saves him 25% tax of £2,432. Fred also receives tax relief of £2,500 on his personal pension contribution, increasing his contribution to £12,500.
Net and gross pension contributions
In the earlier example, the net contribution of £10,000 receives tax relief of £2,500 increasing the total pension contribution to £12,500. This is the gross pension contribution. Individuals looking to contribute £20,000 to a pension, only need contribute £16,000 as HMRC will add tax relief of £4,000, making the total contribution £20,000. To calculate how much to contribute to your pension, multiply the gross contribution that you want to make to your pension by 20% then deduct this amount to get the net contribution. To calculate how much tax relief a net contribution will attract, multiply the amount by 25% (e.g.: £10,000 x 25% = £2,500).
Conclusion
Personal and company pension contributions are a tax-efficient way of taking money out of a limited company. Company pension contributions reduce the corporation tax liability. Personal contributions made by the director will reduce the higher rate of tax liability on dividends whilst also receiving tax relief from the government.
Resources:
Tax on your private pension contributions: Tax relief – GOV.UK (www.gov.uk)
How the pensions annual allowance works – Which?
Check out the personal pensions article on our affiliated sister website:
Personal Pension Contributions & Tax Relief – Moneyquids
