Pension Contribution Rules for Small Business Owners

pension savings pot

Retirement planning for small business owners like you and I can take many forms. We can build truly entrepreneurial ventures that pay us a salary long after we stop working in the business itself. We can build up a cash pile in our companies and draw it down over a number of years during our retirement or we can hope to sell our businesses and retire on the proceeds.

There are many ways to plan for your future and in today’s article we’re going to look at the pro’s and con’s regarding pension contributions and how it works for both the self-employed and company directors.

The main point for small business owners is that as we are not PAYE there isn’t an employer making retirement plans for us. We’re not forced into providing for our future and so like many other aspects of running your own business we better do it ourselves if we don’t want to face the prospect of working until we can’t physically work any longer.

The biggest plus for pensions is the tax treatment for contributions and the biggest drawback is the lack of flexibility, in that your money is locked away until you reach the qualifying age to access it.

Let’s look at how it all works

First the basics; pension contributions are not taxed providing you are within the annual contribution limits. You are taxed as you draw money from your pension as if it were part of your income but you don’t pay any tax when you pay in.

How are Pensions Taxed?

  • Contributions are not taxed (you’ll either get any tax returned or your contributions will be grossed up by the amount of tax you would have paid)
  • Draw Downs are taxed as part of your overall income at the time of the drawdown. (for example if you have no other income and you draw £20k from your pension you will be taxed on that pension income as if it were PAYE)

The hope is that by investing your money before paying tax you get the benefit of making a larger investment and hopefully therefore a greater return.

What are the rules around contributions?

In recent years the rules for contributions have become a minefield but I’ll do my best to simplify here. Just please keep in mind you should seek professional advice for your circumstances as its impossible for me to cover all scenarios in this article without making all our head’s spin!

Your maximum annual contribution is £40k per year – possibly

  • Your personal contribution is capped at £40k or 100% of your income. (We’ll revisit this later when we look specifically at company directors)
  • If you earn over £150k then for every £2 you earn over £150k your annual pension contribution allowance is reduced by £1. (to a maximum reduction of £30k – so you’ll always have £10k annually regardless of how much you earn)
  • You can carry unused allowances for 3 years. For the sake of simplicity, we will say that’s £120k plus the current year £40k, making a total of £160k of available allowance. In reality the £40k allowance used to be £50k so you may be able to do more but it will depend on how much you’ve previously deposited.
  • Lifetime Allowance – as well as an annual contribution allowance there’s a lifetime allowance of £1m beyond which you are taxed.

Pension Contributions and Company Directors

Most company directors will take a small salary topped up by dividends but this can cause a slight issue for pension contributions.

As noted earlier your maximum tax-free pension allowance is capped at 100% of your annual income or £40k. For this calculation dividends are excluded so a director receiving a small annual salary of £8060 would have their personal tax-free pension allowance capped at that amount.

There is a way round this however and that’s for the company to make the contribution on your behalf. For this type of contribution only the £40k annual allowance cap need be considered along with however much allowance is remaining from previous years.

Any contribution made direct from your company will be a tax-deductible expense so you’ll pay less corporation tax.

If we assume net profits of £20k would normally attract corporation tax at 19% which equals £3800.

Now if you were to make a pension contribution of £10k from those net profits it reduces your tax able profits to £10k and your tax liability to £1900. (plus you’ve tucked away £10k in your pension)

Contributions tie up capital but they are very tax efficient.

Pension Contributions for the Self-Employed

With no company to pay contributions on your behalf all deposits will be treated as having come from your personal funds and as such you pension provider will most likely gross up your contribution to account for the tax allowance.

For example, if you pay in £100 then your pension provider claims the 20% tax relief on your behalf and deposits £125 into your scheme.

If you are a higher rate taxpayer then there will be an additional tax relief applied when you complete your self-assessment. This works by expanding your basic rate tax band by the value of your net contribution which will reduce the tax on that value from the higher rate band to the basic rate band.

Conclusion

As small business owners we have many options open to us when planning for our retirement and more than likely you’ll have more than one plan.

Contributing to a pension is just one very simple and tax effective way to reduce the possibility of having to work until we drop!

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