Business owners tend to try and structure their income tax efficiently, but this can be enhanced further with a little planning.
Fundamentally, other than the £3,600 annual contribution available to everyone, you can only place funds into a pension if it is from earned income. This excludes rental or investment income and dividends.
For a business owner, the most significant proportion of their income tends to come from dividends as it avoids National Insurance contributions.
However, it is still possible to gain a significant income tax advantage from a pension contribution.
By way of an example, a business owner pays themselves a small salary of £1000 per month, £12,000 per annum, but has a further, say, £60,000 in dividends. They will be higher rate taxpayers paying 40% tax.
Let us assume that they decide to contribute £12,000 to a pension for themselves. I like to think of it as deferred income for later in life. They would actually pay £9,600 net as the pension provider would claim the balance from the His Majesty’s Revenue and Customs (HMRC). However, their taxable income would be reduced by the full £12,000. This means that £12,000 of their dividend income would be taxed at 8.75% rather than 33.75%. That equates to a saving of £3,000 and gives an effective tax relief rate of 45% on the contribution made!
The system is known as relief at source, and higher rate taxpayers need to inform HMRC of the contributions made to the pension to gain the higher rate of relief.
It seems to me to be very attractive to have the taxman contributing almost half of my annual pension contribution, which I shall go on to enjoy at some point in the future.
Remember too that the pension is invested in a tax advantaged environment and is not part of your estate for Inheritance Tax purposes.
A little careful planning can be well worthwhile.