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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