How will tax rates on pensions compare to dividends?

The issue

Broadly speaking, company shareholders have the option of extracting profits as either a dividend or a pension contribution (once we have dismissed salary and bonuses). With the increase in corporation tax from 19% to 25% from 1 April 2023, I thought that it would be worth recapping on how the effective tax rate looks under each scenario.

Clearly dividends and pension contributions are not directly comparable because a shareholder can spend his dividends whereas the pension contributions are locked away. However, there are many shareholders who have the luxury of being able to take a long term view and look at the ‘big picture’.

Net income from £1,000 of company profits paid as a dividend to a 40% taxpayer

1. £1,000 is reduced by corporation tax of 25% to become £750.
2. £750 is then reduced by 32.5% of dividend tax to become £506.

Net income from £1,000 of company profits paid as a pension contribution and then paid out of pension scheme to a 40% taxpayer

1. The whole £1,000 can go into the scheme as this is a tax deductible expense.
2. £250 (25%) can ultimately be received tax-free from the scheme.
3. Assume that the remaining £750 is taxed at 40% to leave £450.
4. Therefore £700 net income is ultimately extracted which is nearly 40% more than under the dividend scenario.

Forbes Dawson view

This kind of reasoning has always applied to pension payments, but it will be more relevant when corporation tax rates increase. The increase should act as a prompt for entrepreneurs to review their pension position, especially as it is not uncommon for them not to have a pension at all. The tax efficiencies above could end up being greater if the shareholder were to extract pension income at a lower rate than 40% or if his or her family benefit from the fund tax-free in the event of the shareholder dying before the age of 75. Because the £40,000 annual pension allowance (which can be carried forward for three years) only accrues for scheme members, it makes sense for everyone to join a pension scheme whether or not they currently envisage their company making any contributions.

 

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