Chancellor Jeremy Hunt warned in November 2022 that everyone will pay a bit more tax as a result of his Autumn Statement; and the effects of his measures are already being felt.
HMRC’s latest tax data, published earlier this week, revealed that receipts from income tax, capital gains tax, national insurance (NI) and inheritance tax (IHT) all rose sharply between April and July 2023 compared to the same period 12 months ago.
But while income tax and IHT may have grabbed the headlines, the situation with corporation tax is even more striking.
During the same four-month period, the government raked in just shy of £30 billion, a 17% (£4.36 billion) uptick on last year. In April, the top rate of corporation tax was jacked up from 19% to 25%, which is expected to give the Treasury an extra £18 billion a year.
The upshot here is that over the coming years many business owners will see more of their profits go to the taxman. But thankfully, with a bit of planning there are ways to mitigate this. Let’s examine how directors of private limited companies can use self-invested personal pensions (SIPP) to protect their profits.
How does the new corporation tax regime work?
There are now two main rates of corporation tax.
For profits under £50,000, a rate of 19% is applied, while profits over £250,000 are taxed at 25%.
Where a private limited company’s profits land between £50,000 and £250,000, it will pay tax at the main 25% rate, reduced by a marginal relief. In short, this means you will pay less than the top rate.
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This new regime was originally announced at the 2021 Spring Budget and was rubber-stamped by Hunt earlier this year. Previous chancellor, Kwasi Kwarteng, proposed to keep corporation tax at 19% during his emergency mini-Budget in September 2022, a decision that Hunt reversed just weeks later after Kwarteng resigned.
Who is this impacting?
We may assume that corporation tax applies only to largish companies, with vast structures and dozens of employees. But of the 5.5 million UK private sector businesses, 74% do not employ anyone aside from the owner(s). Many are effectively one-man bands.
Many freelancers and contractors structure their affairs as private limited companies for the tax benefits. But higher corporation tax rates could squeeze these perks at a time when, due to the cost-of-living crisis, every penny counts.
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Despite the recent hike to 25%, corporation tax receipts had been rising sharply for the best part of a decade. In 2013-14, payments totalled £38.93 billion, but by 2022-23 had doubled to £78 billion.
How can pensions help directors save tax?
When it comes to taking profits, owner/directors of private limited companies typically have three options that they can mix and match: draw it as salary, take dividends or stick it in a pension.
If you require the money to meet everyday needs, a pension is unlikely to be the right home. That’s because you can’t access it until you are aged 55, rising to age 57 from 2028.
But what’s the scenario for excess profits where there’s no immediate need for the money? Let’s crunch the numbers and check out the tax implications for each option.
For the sake of simplicity here, I’ve assumed that the director is already a higher-rate taxpayer and is seeking ways to withdraw £50,000 worth of excess profit that falls into the 25% corporation tax bracket.
|Employer NI||£6,231 (13.8%)||0||0|
|Income/dividend tax||£17,508 (40%)||£12,319 (33.75%)*||0|
*Includes £1,000 dividend allowance. Note this allowance will fall to £500 from 6 April 2024.
As the table shows, in this scenario the net benefit of paying into a pension is roughly double when compared to receiving the money as a bonus or dividends.
This is, of course, a specific and somewhat extreme example. Not many business owners have the luxury of £50,000 in excess profits. But it serves to highlight that company pension contributions of any size can help thin your tax bill. What’s more, it can also give your retirement savings a welcome boost.
As pension contributions made by the company are deemed an allowable business expense - provided the ‘wholly and exclusively’ test is met - there is no corporation tax to pay. In addition, unlike drawing the money as salary, it escapes employer and employee NI.
Also, limited company owner/directors can pay up to £60,000 a year into a pension without the 100% earnings restriction applying. This is useful for those who usually take a small salary and the rest in dividends.
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The one aspect we can’t overlook is that once you start to draw your pension, the money will become taxable. But given that 25% of this sum can be drawn tax-free, and the rest is likely to fall within the basic-rate tax bracket, the pension contribution would still be far more favourable in terms of tax. But even if you pay higher-rate tax, the argument still stacks up. And as pensions are typically considered outside your estate, the money will also be sheltered from IHT.
Self-employed pensions crisis looming?
It’s fair to say that most of us should shovel more into our pensions, but the situation with self-employed workers is particularly pressing.
Research by IPSE (the Association of Independent Professionals and the Self-Employed) earlier this year found that fewer than a third (31%) of self-employed workers are saving into a pension.
Now, this does not necessarily mean those who swerve pensions are neglecting their retirement. They might plan to rely on other assets such as their business itself, individual savings accounts (ISA), or buy-to-let properties to fund their retirement lifestyle.
But for self-employed workers without a plan, there is a risk they could reach later life with insufficient savings to afford to stop working. Plus, as outlined above, they could be missing out on some prudent tax breaks.
Why do SIPPs suit self-employed workers?
While it’s always best to start when you’re young, it’s never too late to make a difference to your retirement savings. And if you don’t have access to auto enrolment, a great alternative is to use a SIPP.
All self-employed workers, whether limited company owners, sole traders, or those in partnership, tend to have irregular earnings.
The IPSE research found that 54% of the self-employed workers said the flexibility to pause, stop and restart payments without incurring penalties was one of their top three most-preferred options; something a SIPP can cater for.
A SIPP allows you to either make regular contributions, pay in lump sums, or use a combination or the two. A common strategy for business owners is to make affordable monthly payments and add a lump sum towards the end of the tax year when annual profits become clearer.
Can freelancers make personal pension contributions?
The simple answer to this is yes, but if you run your business as a private limited company this is unlikely to be your best option.
With personal contributions you receive an up-front 25% boost in the form of basic-rate tax relief. If you’re a higher or additional rate taxpayer, you can claim back an extra 20% or 25% of the gross contribution via your tax return. In most cases, however, it’s more tax effective to contribute directly from the company, but it’s worth seeking help from a financial adviser to make sure what you’re doing is both affordable and suitable.
But whichever way you choose, the thing to remember is that paying into a pension comes with attractive tax breaks which can help get you closer to your retirement goals.
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Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.
Important information – SIPPs are aimed at people happy to make their own investment decisions. Investment value can go up or down and you could get back less than you invest. You can normally only access the money from age 55 (57 from 2028). We recommend seeking advice from a suitably qualified financial adviser before making any decisions. Pension and tax rules depend on your circumstances and may change in future.
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