Tax and profit extraction
Dividends are subject to income tax at a number of rates, depending on whether you are a basic rate taxpayer, higher rate taxpayer, or additional rate taxpayer. For the tax year ended April 2020, the first £2,000 in dividends is exempt from income tax. The balance is taxed at 7.5% for basic rate, 32.5% for a higher rate, and 38.1% for additional rate payers.
However, if you don’t need the cash income, you should consider reducing dividends in favour of pension contributions for longer-term tax efficiency.
One added bonus is that dividends can’t be paid where the company operates at a loss, even if if it has the cash to pay dividends. The same isn’t true for pension contributions.
Company or personal contributions
Registered pension schemes can accept contributions from you personally or direct from your company on your behalf. The latter, known as employer contributions, are slightly more tax efficient.
If your pension plan doesn’t accept employer contributions, it’s usually easy to make a change to allow them. Speak to the Inchmead financial services team who will be able to assist you.
How much can you pay?
While your company can pay substantial amounts into a registered pension scheme, for you there is a point at which they become less tax-efficient than taking equivalent dividends. The optimum amount is that which brings your total pension contributions up to £40,000 in a year.
If annual allowances haven’t been fully used in the last three tax years, your company can use them to make a larger pension contribution in 2020/21.
For example: if your total pension contributions were £8,000 for each of 2017/18, 2018/19 and 2019/20, the shortfall of £32,000 per year, £96,000 in total, is added to your annual allowance for 2020/21.
Tax savings - pension v dividends
The table below shows the net income you would receive per £1,000 taken as a dividend or paid by your company to your pension fund and later taken as pension income.
Source: PensionBee