Why a pension could be the best way for your clients to extract profit from their business

Why a pension could be the best way for your clients to extract profit from their business

Posted on May 10, 2021 at 10am

When trying to extract money from a client’s business, there are a variety of obstacles to overcome in the form of Corporation Tax, Income Tax, National Insurance Contributions, and Dividend Tax. With all these taxes, helping your client access the money in their company can feel like an uphill battle.

One potential way that your client could get around this issue is by paying into a pension instead, as they may be able to pay a lower rate of tax in retirement. Read on to find out why this may be the best way for your clients to extract profit from their business.

There are three main ways to extract profit: salary, dividends, and pension contributions

If your clients are looking to extract profit from their own company, there are essentially three ways to do so. The first is through their salary, the second through dividends, and the third through pension contributions.

Alternatively, the client may leave the profit in the company and take the proceeds when they sell the business. However, this isn’t always the best decision for their long-term financial wellbeing.

To understand the pros and cons of each option, let’s look at the three possibilities in turn.

An increase in the client’s salary may lead to profit being lost due to taxes

In this scenario, if the client extracts more profit via a salary increase, they will be taxed as an employee of the company.

In the 2021/22 tax year, they will have a Personal Allowance of £12,570 per annum and anything above this is taxed at:

  • 20% on annual earnings above the Personal Allowance threshold and up to £37,700
  • 40% on annual earnings from £37,701 to £150,000
  • 45% on annual earnings above £150,000

Please bear in mind that different rates and additional bands may apply in Scotland and Wales.

Furthermore, the client will also have to pay National Insurance contributions on top of this. Typically, most employees pay 12% of earnings between £184 and £967 per week, and 2% on anything above £967 per week.

Extracting profit through dividends may also incur tax liabilities

If your client chose to extract profit in the form of company dividends, they may have to pay tax on these.

In the 2021/22 tax year, you can earn up to £2,000 in dividends before you have to pay tax. After this threshold, the dividends are taxed according to your tax band.

  • Basic rate – 7.5%
  • Higher rate – 32.5%
  • Additional rate – 38.1%

Another issue to consider with trying to extract profits through dividends is that they do not count as “earnings” when considering Annual Allowance.

For example, if your client took £10,000 as salary and £90,000 as dividends, they could only pay £10,000 into their pension and still get tax relief.

Pension contributions can be a tax-efficient way of extracting profit from the company

If your client wants to avoid the tax bills that they can accrue through taking profit in the previous two methods, paying into a pension could be a much more tax-efficient option.

In the 2021/22 tax year, the Annual Allowance is £40,000, which is the maximum amount that your client can put into their pension per year and still receive tax relief on their contributions. If they have an adjusted income of more than £240,000 per year, however, their allowance is reduced.

If your client was to make pension contributions through their company instead, rather than as an individual, this can have several advantages.

Firstly, pension contributions made by the company can be an allowable business expense, reducing profit and meaning that they would pay a smaller amount of Corporation Tax.

Furthermore, unlike with personal contributions, there is no limit on how much a company can pay into a pension scheme, meaning your client can put away that money without it being eaten away by tax.

When your clients are able to make withdrawals from their pension, they can take out the first 25% without needing to pay tax on it. After this, any withdrawals will be taxed based on their tax rate band, which is typically lower in retirement than when they are in full-time work.

This can make pension contributions an attractive way for clients to extract profit from their businesses.

Extracting profit through pensions may help to lessen a client’s Inheritance Tax liability

A final benefit of extracting profit through a pension is that your client may be able to avoid Inheritance Tax on it.

If your client passes away before the age of 75, pension benefits are free of tax when they are paid out to another individual. After this age, however, the pension benefits will be taxed at the beneficiary’s marginal rate of tax.

Furthermore, if the business still has value when your client passes away, the inheritor of the company can sometimes claim relief for some assets which the business holds.

Depending on the assets, the relief may be as high as 100%, which can reduce their Inheritance Tax bill by a considerable amount.

Get in touch

If you have clients who may want to extract profit from their business in this way, we can help. Email enquiries@prosserknowles.co.uk or click here to request a call back from one of our advisers.

Please note:

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.

Workplace pensions are regulated by The Pension Regulator.

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