Slaughtering the sacred pension cow

If you wish to save for your long-term future the best way to do it is to make contributions into a pension scheme. But is it? Owner directors of limited companies have opportunities to limit their overall tax liabilities that can be ruined by making contributions to a personal pension scheme.

Most people in this position take dividends from their companies instead of salaries. Unfortunately, National Insurance applies to the salary but not to dividends. As the maximum amount payable into a pension is dependent on earned income (which does not include dividends) the scope for making pension contributions is limited. Conventional wisdom has it that the salary should be increased in order to make the required contributions. Is this correct? In pure financial terms the answer is surprisingly almost always no.

Take for example, a 40 year old man earning £40,000 in his own company with only a £5,000 salary and the balance in dividends who now wishes to increase his annual pension contributions from £1,000 to £3,000. To do so, he must increase his salary up to £15,000. If he does this the total amount of National Insurance payable by either he or his company will increase by £1,300 in order to save tax at 40% of £800. Furthermore, once the money is in a personal pension fund 75% of it will have to be used to purchase an annuity. When the monthly annuity is received the entire amount will be taxable.

Ignoring the annuity issue, which is hard to quantify, the effect is an increase in the overall tax bill of £242.75. The difference is even larger for someone who is not a higher rate taxpayer and greater still when larger pension contributions are involved.

So what are the alternatives? Firstly, pay at least £3,600 into a personal pension. This amount can be contributed whatever your earned income (even if it is zero). Secondly, look for a year in the last six when your earned income was high, such as a time when you were self-employed or had high benefits in kind. This year can be used quite legitimately as a base year for contributions in the next five years. Other alternatives could be using an Executive Pension Plan, which may allow you to pay significantly more into it or perhaps finding a different investment altogether such as an ISA as a way of saving for retirement. Tax relief is not available on contributions in but no tax will be payable when the funds are taken back out. Importantly, the taxpayer will not have to increase his or her salary in order to invest in an ISA.

So why would someone fall into the trap of paying a high salary purely to pay into a pension? The answer is very simple. Most business people have financial advisers and accountants. Unfortunately, they either work in isolation to each other or having discussed the issue neither takes the time to work out the overall effect on the individual.

If you are looking to provide for a comfortable future do not accept what seems to be fact.

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