Company shareholders have the option of extracting profits as either a dividend or pension contribution. With the impending increase in corporation tax from the 1st April 2023 from 19% to 25%, we take a look at how the effective tax rate looks under each scenario.
Dividends and pension contributions are not directly comparable because dividends are cash whereas pension contributions are locked in.
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. £1,000 can go into the scheme as a tax deductible expense
2. 25% can be received tax-free from the scheme, ie, £250
3. Assuming the remaining £750 is taxed at 40% this would leave £450
4. Therefore £700 (£250+£450) net income is extracted, nearly 40% more compared to the dividend scenario
Pensions have always been very tax efficient, but when the new rates for corporation tax come into force it will be more relevant than ever.
The increase should prompt entrepreneurs to review their pension position, especially as it is not uncommon for them not to have a pension at all.
Pension rules are complex area and professional independent advice should always be taken.