Tax-Efficient Profit Extraction Using Salary, Pension and Dividends (UK)
Overview
Company: DEF Ltd.
Owner: Michael, the sole director and 100% shareholder.
Annual Profit: £150,000 (before any salary, dividends, or pension contributions).
Current Personal Allowance (2023/24): £12,570.
National Insurance Contributions (NICs) Thresholds:
- Primary Threshold: £12,570 (Employee NICs start above this).
- Secondary Threshold: £9,100 (Employer NICs start above this).
- NIC Rates: Employee NICs at 12% up to £50,270, 2% thereafter; Employer NICs at 13.8%.
- Annual Pension Allowance: £60,000 (for most people, this is the maximum amount that can be contributed to a pension each year without incurring a tax charge).
Objective: Michael aims to extract profits in a tax-efficient manner, prioritizing long-term retirement savings through pension contributions.
Strategy
Michael decides to adopt a strategy combining a minimal salary, dividends, and significant pension contributions made by the company. This strategy maximizes tax efficiency by reducing immediate taxable income and leveraging the tax advantages of pension contributions.
Step 1: Determine Salary
Michael decides to pay himself a salary just above the secondary NIC threshold, set at £12,570, which:
- Personal Allowance: Completely uses Michael’s personal allowance, ensuring he pays no income tax on his salary.
- Employer NICs: Minimal because the salary is just above the NIC secondary threshold.
- Employee NICs: None, since the salary equals the primary threshold.
- Salary: £12,570
- Secondary NIC Threshold: £9,100
- NICs Payable = (£12,570 – £9,100) * 13.8% = £479.46
Step 2: Make Pension Contributions
Michael decides that DEF Ltd. will make an employer pension contribution of £40,000 into his pension. This decision is based on the following considerations:
- Pension Contributions as a Business Expense:
- Pension contributions made by the company are a deductible expense, reducing the company’s taxable profits.
- This means the corporation tax liability is lowered.
- No NICs on Pension Contributions:
- Pension contributions are not subject to National Insurance Contributions (NICs), making them more tax-efficient compared to additional salary.
Step 3: Calculate Corporation Tax
- Initial Company Profit: £150,000
- Less Salary: £12,570
- Less Employer Pension Contribution: £40,000
- Less Employer NICs: £479.46
- Adjusted Profit Before Tax: £150,000 – £12,570 – £40,000 – £479.46 = £96,950.54
- Corporation Tax (at 19%): £96,950.54 * 19% = £18,420.60
Step 4: Determine Available Dividends
After salary, pension contributions, and corporation tax, the remaining profit can be distributed as dividends:
- Post-Tax Profit: £96,950.54 – £18,420.60 = £78,529.94
Step 5: Dividend Tax Calculation
Michael takes dividends from the remaining profit. The dividend tax rates for 2023/24 are:
- 0% on the first £1,000 (dividend allowance).
- 75% within the basic rate band (up to £50,270 after salary).
- 75% within the higher rate band (anything above £50,270).
- Basic Rate Dividend Tax:
- Michael’s taxable income after salary is £78,529.94 – £12,570 = £65,959.94.
- First £1,000 is tax-free (dividend allowance).
- £37,700 (basic rate band) * 8.75% = £3,298.75.
- Higher Rate Dividend Tax:
- Remaining dividends: £65,959.94 – £37,700 – £1,000 = £27,259.94.
- £27,259.94 * 33.75% = £9,198.74.
Total Dividend Tax: £3,298.75 + £9,198.74 = £12,497.49.
Step 6: Calculate Michael’s Total Net Income
- Net Salary: £12,570 (no income tax or NICs due).
- Net Dividends: £78,529.94 – £12,497.49 = £66,032.45.
- Total Net Income (excluding pension contribution): £12,570 (salary) + £66,032.45 (dividends) = £78,602.45.
Step 7: Total Tax and NICs Liability
- Corporation Tax: £18,420.60.
- Employer NICs: £479.46.
- Dividend Tax: £12,497.49.
- Total Tax and NICs: £31,397.55.
Benefits of Pension Contributions
- Immediate Tax Savings:
- The £40,000 pension contribution is fully deductible against corporation tax, saving the company £7,600 (£40,000 * 19%) in corporation tax.
- Long-Term Retirement Planning:
- The pension contribution grows in a tax-advantaged environment, with no income tax or capital gains tax on investment growth within the pension fund.
- Michael can access his pension from age 55 (rising to 57 in 2028), with 25% of the fund available as a tax-free lump sum.
- NIC Savings:
- Pension contributions are not subject to employer or employee NICs, making them more tax-efficient than salary.
Comparison and Analysis
- Tax Efficiency:
- By combining a minimal salary, dividends, and a significant pension contribution, Michael significantly reduces his immediate tax liability.
- He maximizes tax-free growth within the pension and ensures tax-efficient extraction of profits from the business.
- Retirement Planning:
- Pension contributions serve as a valuable tool for long-term financial security, providing benefits both in terms of tax efficiency and retirement planning.
- Flexibility:
- Although the pension contribution reduces Michael’s immediate disposable income, it builds wealth for the future, leveraging the tax advantages of pensions.
Conclusion
Using pension contributions as part of a mixed strategy for profit extraction offers substantial tax efficiency for owner-directors like Michael. By paying himself a modest salary, extracting some profits as dividends, and making significant pension contributions, Michael minimizes his immediate tax liability while investing in his long-term financial security. This approach ensures that DEF Ltd. benefits from reduced corporation tax and NICs, while Michael enjoys tax-efficient savings for retirement.