Switching dividends for pension contributions?

February 24th 2021

Generally speaking, if you are a director shareholder, dividends are the most tax-efficient way to extract profit from your company. However, company and personal circumstances can change that, so are pension contributions worth considering too? Partner and Tax expert Brona MacDougall takes a closer look.

Since 2016, the government has introduced a number of measures that have eroded the personal tax advantages for director shareholders of companies, in particular increased income tax on dividends. Nevertheless, with few exceptions dividends produce the greatest net income for shareholders compared with taking income in other forms, e.g. salary or benefits in kind. However, if you do not have an immediate need for income you should consider reducing dividends in favour of pension contributions for longer term tax efficiency.

Company or personal contributions
Registered pension schemes can accept contributions from you personally or direct from your company on your behalf. The latter, known as employer contributions, are slightly more tax efficient.

If your pension plan doesn’t accept employer contributions, it’s usually easy to make a change to allow them. Speak to your financial advisor or the pension company. Pension contributions also have the advantage that your company can pay them even where it hasn’t made profits. This isn’t allowed with dividends.

While your company can pay substantial amounts into a registered pension scheme, for you there is a point at which they become less tax efficient than taking equivalent dividends. The optimum amount is that which brings your total pension contributions (personal and company) up to £40,000 in a year (the annual allowance).

If annual allowances haven’t been fully used in the last three tax years, your company can use them to make a larger pension contribution.

Pension income is a winner whether you’re a basic or higher rate taxpayer. But you’ll have to wait until you’re 55 to get the pension money and so there’s a trade-off between immediate need for income and long-term tax efficiency.
If you don’t need to take all the profit from your company, extracting it as an employer pension contribution is a more tax-efficient alternative. In the long run it could save you tax of almost £40 per £1,000 of income if you’re a basic rate taxpayer, or £150 per £1,000 if you pay higher rate tax.