Pension contributions are one of the most significant tax planning opportunities available. Pension tax relief can reduce the taxable profits of the business. At the same time, pension contributions also offer substantial income tax and National Insurance advantages.
Tax relief on pension contributions made by employees
Pension contributions made by an employee benefit from income tax relief. Tax relief on pension contributions is available for up to 100% of earnings, provided the employee is under 75. Both employer and employee will still pay any National Insurance contributions that are due.
Pension tax relief is restricted by an annual allowance of £40,000. There is no tax relief on pension contributions in excess of the annual allowance unless you have unused allowances (up to the maximum £40,000), which you are allowed to carry forward for up to three years.
The way tax relief on pension contributions is given depends on the particular scheme. With occupational schemes, employees’ pension contributions are generally paid into the scheme without any tax being deducted, automatically giving pension tax relief at whatever rate of income tax the employee pays.
Pension contributions into a personal pension scheme are made out of the employee’s taxed income, with the pension scheme then claiming back basic rate pension tax relief. Individuals who pay higher rates of income tax generally claim the difference back through their own self-assessment tax returns.
Tax relief on employers' pension contributions
Employers’ pension contributions can generally be claimed as an allowable business expense — provided the pension contribution meets the normal rules requiring expenses to be wholly and exclusively necessary for business purposes. If the pension contribution is much larger than normal, the pension tax relief may need to be spread over up to four years.
In addition, neither employers nor employee's National Insurance contributions are payable. So tax relief on pension contributions is more generous if the employer makes the pension contribution, rather than the employee.
However, employers’ pension contributions do count towards the individual’s annual allowance. If the employer makes pension contributions that take total contributions over the allowance, the individual is taxed at their marginal rate of income tax.
All employers are being required to automatically enrol eligible workers into a workplace pension scheme and make contributions to the scheme. This is being phased in from October 2012. You can find out more about automatic enrolment by visiting The Pensions Regulator website.
Pension contributions and tax planning for owner-managers
Tax relief on pension contributions made by the self-employed operates in the same way as for employees. The pension scheme claims back basic rate tax, and any additional pension tax relief is claimed through the self assessment tax return.
If you own your own company, the company can only make pension contributions for you if you are an employee of the company. Provided that is the case, the normal rules apply.
As a business owner, you should consider pension contributions as part of your broader tax planning, along with other options such as paying dividends. You may also want to consider the way pension funds are invested. For example, you might use your pension scheme to invest in your commercial premises.
If you want the company to make pension contributions to someone else (for example, your spouse) they will also need to be an employee and the contribution needs to be justifiable as a business expense. A large pension contribution (or indeed salary) for a spouse who does little work might be challenged by HM Revenue & Customs.
If you have a non-working spouse, you may want to consider making small pension contributions on their behalf. Basic rate tax can be reclaimed even if your spouse has no income, up to an annual pension contribution limit of £3,600 (including the value of the tax reclaimed). The same approach can be taken with pension contributions for your children.
Business owners (and high earners generally) should bear in mind that there is a lifetime limit of £1 million on pension funds (2016/17). If the value of your pension fund exceeds this limit then additional tax is payable on excess lump sums and pension income taken in retirement.