One of the best ways for Limited Company Owner/Managers to reduce Corporation Tax is through pension contributions.
Pensions are great from a tax perspective because they provide a way for you to extract money from your company in a way that reduces Corporation Tax but doesn’t result in any Income Tax.
There are two notable downsides though:
- The funds will be locked away until you retire; and
- You will pay income tax when you draw down the pension
Pension contributions can be made directly by the company or by you personally. Both have the same tax advantages though the personal contribution involves making complex adjustments to your income tax return and are more limited in how much you can contribute. Since both methods end up in the same place tax-wise, we much prefer the simpler company contribution route.
Making contributions through your Company
If you have excess funds in your company you can make a payment directly from the company to your personal pension scheme. Pension contributions are an allowable expense so will attract corporation tax relief.
That means if you pay £10,000 into a pension your Corporation Tax will reduce by £2,000 (20% of £10,000).
You are limited to contributions of £40,000 per year, though if your allowance has not been fully utilised in the previous two years you can roll these up, as long as you already had the pension scheme setup at that time.
It is vital that you tell your pension provider that the contribution has been made by a company. This is because the way the pension provider treats the contribution is different (there are none of the complicated grossing up procedures mentioned below).
Aside from informing the pension provider there is nothing else you need to do.
Making contributions personally
Personal pension contributions are more complex. Instead of getting a reduction in tax when paying, the government ‘grosses up’ your pension contribution to take account of the tax you paid when initially receiving the income.
This is probably best explained with an example, let’s say you received a salary of £40,000 in the 2014/15 income tax year and contributed £10,000 of that into a pension.
When you receive a salary, tax is deducted through the PAYE system before you receive any of it. A salary of £40,000 in 2014/15 would have suffered approximately £6,000 in tax deductions.
When contributing £10,000 to a pension, the pension provider grosses up your contribution to factor in the tax you suffered when receiving the salary. So a £10,000 contribution turns into £12,500 sitting in your pension fund (calculated as £10,000 / 0.8).
That is how it works for a basic rate tax payer but what if you are paying 40% income tax on a salary of £60,000:
- You still get the gross up amount deposited in your pension (being contribution / 0.8); and
- Your higher rate tax threshold is increased by £12,500 to account for the higher rate tax suffered.
So whereas someone would normally start paying higher rate tax when they hit the £42,385 threshold (2015/16), pension contributions will increase that band so you don’t pay higher rate tax until you cross the new higher threshold (£54,885 in the example above). This can result in a tax refund for some higher rate taxpayers making pension contributions.
Limits on personal contributions
Whilst a company can contribute up to £40,000 per employee, an individual can only contribute the lower of £40,000 or the amount they earned during the tax year. So if you earned £30,000 before tax in the year, you will only receive tax relief on pension contributions of up to £30,000.
Or, if you earned £60,000 during the tax year, you will only receive tax relief on £40,000 of pension contributions.
Please note that all information above is correct as at September 2015. However, pension and tax rules do change regularly.