Tax relief on pension contributions unravelled

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There has been much discussion on the impact of the dividend tax on total tax bills and the incentive to incorporate.

What has been less widely examined is how the new regime affects marginal tax rates, and the knock-on effect this has on the tax relief given to pension contributions. This article will look at the tax relief available on pension contributions made from an OMB company, and how this compares to the relief given to the same taxpayer on personal contributions.

Our test case owner-manager

All our calculations will be performed for a business person operating via a limited company. The owner draws a salary equal to the personal allowance of £11,500, and pays all post-tax profits in dividends to themselves as 100% shareholder. He or she has the choice of making pension contributions either as an employer or as an individual. Our tax relief figures are shown as a percentage of the money added to the pension fund, taking into account any income or company tax savings plus any tax reclaimed by the pension provider.

Tax relief on personal contributions

As well as the pension fund claiming back the basic rate tax paid on personal pension contributions, the taxpayer receives further tax relief via the extension of his or her basic rate tax band. In our example this means the owner receives tax relief of a further 25% (i.e. 32.5% less 7.5%) if they are in the higher rate band, or 30.6% (38.1% less 7.5%) as an additional rate taxpayer. In addition, the income used to calculate any reduction in the personal allowance is also scaled back by the grossed-up value of their pension contribution.

The total tax relief available on personal pension contributions is shown below for various bands of profit and personal income.

Table 1: Tax savings from personal pension contributions, 2017/18

Salary Profit Dividends Tax relief (%)
£11,500 £41,358 or lower £33,500 or lower 20%
£11,500 £41,359 - £109,259 £33,501 - £88,500 45%
£11,500 £109,260 - £137,654 £88,501 - £111,500 67.5%
£11,500 £137,655 - £170,987 £111,501 - £138,500 45%
£11,500 £170,988 or higher £138,501 or higher 50.6%

Tax relief on company contributions

To calculate the tax relief on company contributions we need to take into account both the corporation tax saved and also any personal tax that would have been charged on the dividends foregone. There are four dividend tax rates (i.e. 0%, 7.5%, 32.5% or 38.1%) for varying levels of income, and the reduction in dividend payments may also slow the scaling back of the personal allowance.

The table below shows the profit levels associated with these various bands, and the total tax relief the owner/manager will receive (corporation tax and income tax combined) from making a company pension contribution.

Table 2: Tax savings from company pension contributions, 2017/18

Salary Profit Dividends Tax relief (%)
£11,500 £6,172 or lower £5,000 or lower 19%
£11,500 £6,173 - £41,358 £5,001 - £33,500 25.1%
£11,500 £41,359 - £109,259 £33,501 - £88,500 45.3%
£11,500 £109,260 - £137,654 £88,501 - £111,500 63.5%
£11,500 £137,655 - £170,987 £111,501 - £138,500 45.3%
£11,500 £170,988 or higher £138,501 or higher 49.9%

Personal versus company contributions compared

So, given the above figures, should the business owner make personal pension contributions or pay them from company funds? Table three below summarises the total tax relief available for both methods.

Table 3: Tax relief from personal and company pension contributions, 2017/18

Profit level Tax relief on personal contributions (%) Tax relief on company contributions (%) Difference
£6,172 or lower 20% 19% -1.0%
£6,173 - £41,358 20% 25.1% +5.1%
£41,359 - £109,259 45% 45.3% +0.3%
£109,260 - £137,654 67.5% 63.5% -4.0%
£137,655 - £170,987 45% 45.3% +0.3%
£170,988 or higher 50.6% 49.9% -0.7%

So there are some significant differences between the two methods. Company contributions are typically the best at lower profit levels, and the advantage peaks (at 5.1%) in the area where the taxpayer has a marginal income tax rate of 7.5%. However there are other areas where a personal contribution gives more bang for their buck, with the maximum difference (4%) in the profit band where any change to personal income affects the personal allowance available.

Conclusion

Before making a pension contribution, owner managers should consider the most tax efficient way of doing so given their profit level. Owners may also need to consider non-tax factors, such as cash flow considerations, maximising income for upcoming mortgage applications or whether their current pension provider accepts employer contributions. But, for many profit levels, making contributions direct from OMB companies now makes a lot of sense.

About Matt Bailey

matt_bailey

Founder of Azura Cloud Systems (Gbooks), the leading cloud-based tax and accounts system.

Replies

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19th Apr 2017 10:12

That's all very well. However, you have not factored in the additional complication around the tapering of the individual's annual allowance with the two triggers of threshold income at £110,000 and adjusted income at £150,000 (the latter, of course, includes any employer pension input amounts). You also need to remember that an individual's tax-relief on member contributions is limited to 100% of relevant UK earnings in the year. So if remuneration is limited to £11,500 that's the maximum member contribution on which income tax relief will be allowed.

isn't it nice that pension were simplified by Gordon Brown in the Fiance Act 2004!

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By NH
19th Apr 2017 10:34

and if you have a choice between HMRC adding 20% to your pot or your company saving Corp Tax right now, which would you choose?
Also, to factor in the decreasing rates of CT

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to NH
19th Apr 2017 11:03

Pedantic but HMRC will actually *add* 25% to your pot.

It can often be worth considering making a pension contribution to a non working spouse as they'll automatically received tax relief, regardless, as long as net contributions don't exceed £2880 which will be grossed up to £3600.

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to NH
19th Apr 2017 11:07

double tap...

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19th Apr 2017 11:24

Individuals who have taxable income for a tax year of greater than £150,000 will have their annual allowance for that tax year restricted. It will be reduced, so that for every £2 of income they have over £150,000, their annual allowance is reduced by £1. Any resulting reduced annual allowance is rounded down to the nearest whole pound.

The maximum reduction will be £30,000, so anyone with income of £210,000 or more will have an annual allowance of £10,000. High income individuals caught by the restriction may therefore have to reduce the contributions paid by them and/or their employers or suffer an annual allowance charge.

This will be at a penal rate.

It may be possible to contribute more if carry forward is available - ie previous years pension contribution were less than the maximum.

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19th Apr 2017 12:58

I did the following calculation for a limited company client recently who wanted to know whether to invest personally or through the company:

Personal contributions:
Turnover £79141, salary £8160, overheads £5500 less Corporation Tax £12441 = £53040 profit after tax for dividends. Dividend tax due £6440. Personal pension contribution £4800 plus 20% tax relief of £1200 = £6000 in pension pot.

Total of salaries, dividends and pension pot = £55960

Company contributions:
Same turnover, salary and overheads with a £6000 company pension contribution, gives taxable profit of £59481 less Corporation Tax of £11301, gives dividends of £48180 that attract Dividend Tax of £6360.

Total of salaries, dividends and pension pot = £55980

Better off making company contributions by £20!

It is important in this exercise to compare pension pots that are the same size, because this eliminates the need to take into account the superior growth rates on the difference if they are unequal. It is not all about tax relief, as others have noted too.

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19th Apr 2017 16:47

What about Net relevant earnings. Personal pension contributions are capped at NRE. Therefore dependent on how much you want to contribute you may not have the choice.

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to tapsalterie
19th Apr 2017 17:23

Sort of, but not quite...

You can't get tax relief for contributions in excess of REs, but it is in theory possible to pay in more.

You can, however, use carry forward to pay in more, assuming you haven't maxed contributions in previous tax years.

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19th Apr 2017 17:30

The calculations take a very simple scenario and appear to assume that the pension contributions will be paid from dividends, and therefore will be capped at the level of earned income received. When you factor into the equation taking additional salary to pay pension contributions (thereby increasing the amount that can be paid into the pension scheme) the impact of National Insurance tips the benefit squarely into making company contributions.

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20th Apr 2017 11:11

Theres only one thing wrong with the above article, we have had pension misleading at least once in the past, I think history make repeat its self on this one.

Also many people had had thier pension pot adjusted, downwards in most cases.

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to AndrewV12
04th May 2017 12:14

Please expand.

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04th May 2017 12:19

I've just realised a FUNDAMENTAL error here - the income is £11500 with the rest taken as dividends - which are NOT PENSIONABLE.

The MAXIMUM contribution to pension that will attract tax relief is £11500.

If anyone is going to invest in pensions based on this article they could be in for a nasty surprise.

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05th May 2017 18:25
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By mabzden
to Mike Lacey
05th May 2017 10:20

I think you need to get your facts right before you make this sort of comment.

Several users have already made the point about the NRE limit. Incidentally, I seem to remember HMRC saying they wouldn't enforce that limit for people working through personal service companies. But that's irrelevant anyway, because the article is talking about the marginal tax relief on pension contributions, doesn't ever talk about contributions over £11,500 and can't cover every possible scenario.

So there is no fundamental error, and a public apology (from Mike Lacey to the author, the Aweb community and the world) is very much in order.

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to mabzden
05th May 2017 12:31

You can't see why this article is somewhat misleading.
Fair enough.

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By mabzden
to Mike Lacey
05th May 2017 12:52

I don't think anyone other than yourself sees any fundamental error, or even your new claim that it's "somewhat misleading".

The figures in the tables show the marginal tax relief on a small (lets say £1) contribution to a pension fund at various levels of profit. No one is saying all the dividends are being paid into the pension fund, or that the contribution is more than £11,500.

So you seem to have made a fundamental error when reading the article, and your criticism is more than somewhat misleading.

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By mabzden
to Mike Lacey
05th May 2017 15:56

** DEAFENING SILENCE **

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to mabzden
05th May 2017 18:23

Seeing clients.

I note you've now mentioned a premium, unlike the original article.

Is that the sound of as penny dropping?? :-)

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to mabzden
05th May 2017 18:26

<>

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to Mike Lacey
05th May 2017 16:17

A nice man from accountingWEB asked me to add a comment to clear up any misunderstanding about this article.

The tax relief figures quoted are indeed for small, incremental contributions to a pension fund when profits fall within the various bands given. There are, of course, other factors to consider, including the possible cap on the relief available on personal contributions.

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