The Government encourages you to save for your retirement by giving you 'tax relief' on pension contributions. Tax relief reduces your tax bill and/or increases your pension fund.
When you retire, provided your own pension scheme rules allow, you can usually take up to 25 per cent of your pension fund as a tax-free lump sum. Your regular pension income is then taxed in the same way as the rest of your income.
You can obtain tax relief on contributions of up to 100% of your earnings each year, subject to an upper 'Annual Allowance' of £40,000 (Savings above a separate Lifetime Allowance will be subject to tax charges).
Pension Contributions and Controlling Directors
This information is to help you gain an understanding of the legislation and rules surrounding pension contributions. It aims to assist you when considering the options available to you as a controlling director on both an individual level and as a corporate entity.
Legislation surrounding pension contributions changed significantly in April 2006. This was known as “Pension Simplification” or commonly “A-Day”. This legislation is not necessarily ‘simple’ however.
Positively, the new rules created some good opportunities. Negatively, they also created some confusion, which is especially true for those who choose to operate within a limited company business model.
The purpose of the new legislation was to bring all types of pension vehicles under one “simplified” regime.
It means that within the same tax year it is possible to contribute to any mixture of as many different types of pension arrangement as you like - knowing the rules surrounding contribution limits (and eventual benefits) are effectively the same.
In practice this means you or your company can contribute to a mixture of Stakeholder, Company Pension (including Executive Pensions and AVC) Personal Pension or Retirement Annuity Contracts and all within the same tax year.
Contributions levels are however, subject to strict limits
The new contribution limits have two major components:
- Annual Allowance: The total of all contributions (either personal, company or third party) that can be contributed within each tax year is limited by an “annual allowance”. This has been set at £40,000 for the 2014/15 tax-year. If you exceed the annual allowance you will have tax to pay on the contributions that exceed the annual allowance. This effectively removes the tax relief received on the excess contributions. ??There is however a three-year “carry forward” rule that allows you to carry forward any unused annual allowance from the last three tax-years. You must have been a member of a registered pension scheme during the year you wish to carry forward the unused annual allowance.
- Lifetime Allowance: In simple terms, this is the total amount that an individual can hold within pension funds in their lifetime. This is £1.25million from April 2014.
Contributions need to be considered in three different ways:
- Personal Contributions – those paid from an individual’s taxed income or other funds.
- Company Contributions – paid by the company for the benefit of a director or employee.
- Third Party – made by someone other than the individual or an employer/company. For the purposes of this information the company is your limited company and you are the director.
- Within each tax year, up to 100% of the net relevant earnings (NRE) can be made and receive tax relief.
- NRE includes directors’ fees, salary and P11D benefits, however dividends are NOT counted as NRE.
- Personal contributions are normally made net of Basic Rate Tax.
- Higher Rate Tax relief can be claimed through self-assessment.
- If there are no relevant earnings a gross amount of £3,600 can still be contributed and receive tax relief.
Ignoring any other income sources, you can personally contribute a gross amount equal to your net relevant earnings (salary or/and directors’ fees) and obtain tax relief at your highest rate(s). You need to ensure that total contributions do not exceed £40,000 in any one fiscal year or you will have to pay the additional tax on the excess.
It has long been recognised that a company may wish to make pension contributions as part of the remuneration package for its directors or employees. As a director of your own limited company you may wish to structure your remuneration in this way. If the contribution is valid it will be treated as a business expense and therefore reduces the company’s operating profit.
Company Contribution Limits
Technically, it is possible for the company to contribute any amount but consideration should be given to both the annual and lifetime allowance.
Importantly the HM Revenue & Customs (HMRC) are concerned that this added contribution flexibility could be abused and therefore use the “wholly and exclusively” test to ascertain the contributions purpose.
The use of the wholly and exclusively test in relation to pensions initially led to considerable confusion. In response the financial services and accounting professions asked for clearer guidance from HMRC.
HMRC responded and issued a statement containing the following
“Controlling directors are often the driving force behind the company. Where the controlling director is also the person whose work generates the company's income then the level of the remuneration package is a commercial decision and it is unlikely that there will be a non-business purpose for the level of the remuneration package. It should be noted that remuneration does not include entitlement to dividends etc. arising in the capacity of shareholder”.
HMRC reference remuneration as ‘the overall remuneration package that is the combined salary, wages, benefits and pensions contributions.’
Wholly and Exclusively (WAE)
This states that any company contributions “must be paid wholly and exclusively for the purposes of the trade”. This is to ensure there is a genuine business reason for the contribution.
One of the reasons behind this was to stop a business employing a close relative (e.g. their spouse as a part time administrator) and then contributing an unrealistic high company pension contribution and therefore saving tax.
Using “wholly and exclusively” would appear to achieve this but unfortunately the test can also be used in relation to any director or employee.
Increasing Salary to allow higher pension contributions
Many directors choose to pay themselves a low level of salary or directors’ fee. While this efficiently reduces national insurance costs it does limit the amount that the director can personally contribute into a pension and receive subsequent tax relief.
Some advisers and individuals consider increasing the level of salary to support higher personal pension contributions. This typically happens when contributions are being paid into a private pension that is totally independent from your company.
Taxation planning is not regulated by the Financial Conduct Authority
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