At first glance, you would probably assume that sole trader pension contributions and those from a limited company would be similar in scope. Upon further investigation, you will find that the tax benefits and the broader implications are very different. Consequently, it is essential to weigh the pros and cons of being a sole trader and an employee through a limited company and take professional advice.
Pension contributions
Before we look at the differences between sole trader and limited company pension contributions, it is crucial to appreciate the basic concept of pension funding. All contributions from an individual, company or a mixture of the two will attract tax relief. If we leave aside the sole trader or limited company status, the basic tax relief on personal pension contributions is as follows:-
Income: £0 to £3600 a year
Tax relief: 20%
Maximum contributions attracting tax relief: £2880
The figure of £2880 is net, your after-tax payment, which equates to £3600 a year once the 20% tax relief is claimed from the government.
Income: Above £3600 a year
Tax relief: 20% for basic rate/40% for higher rate, and 45% for additional rate taxpayers
Maximum contributions attracting tax relief: The lower of 100% of your annual gross salary or £60,000
While there are limits on the level of contributions which would attract tax relief, you can pay above this level, but there would be no tax rebate on the excess.
It is important to note that the tax relief is not based on your net contribution; it is based on what would have been your gross contribution. To make a £1000 gross contribution, a basic rate taxpayer will pay £800, a higher rate taxpayer £600 and an additional rate taxpayer £550.
Carrying over your pension contribution allowance
Whether your pension contribution allowance is based on 100% of your salary or the £60,000 limit, any unused allowance can be carried over from the previous three years. The only condition is that you were a pension fund/scheme member during that period and, therefore, eligible to make contributions.
Pension investments
Aside from the tax relief at source, when making pension fund contributions, all investments within your pension fund are shielded from income and capital gains tax. So, while contributions can be a helpful one-off means of increasing your pension fund, the long-term cumulative impact can be significant. In addition, typically, your pension assets are not normally considered part of your estate on death and, therefore, not eligible for inheritance tax. It’s also important to note that your will does not control the distribution of your pension assets.
When looking at the distribution of pension assets on your death, you will come across two forms: “expression of wish” and “nomination beneficiaries”. They are the same. These documents portray your wishes to the pension trustees, although legally, they are not obliged to act on your request. In reality, there would need to be a significant reason for them not to take your wishes into consideration.
Sole trader and limited company pension contributions
There have been many changes in pension regulations in recent years, and the introduction of workplace pensions has revolutionised the industry. When looking at sole traders and those employed by limited companies, it is essential to appreciate the broader tax implications.
Sole trader pension contributions
Contributions into a personal pension plan would be net of taxation and paid from the sole trader’s personal bank account. The pension trustees would receive tax relief on sole trader pension contributions based on the basic income tax rate. Where the individual is on the higher or additional tax rate, they can claim back a further 20% or 25% via their annual tax return.
While an employee could receive pension contributions from their employer, this is different for a sole trader because they are, well, a sole trader.
Employer contributions
Under current regulations, where there is a workplace pension scheme, the minimum contribution is 8% of your gross salary. This is split between the employer and the employee, with the employer obliged to pay a minimum of 3%. The employer could choose to pay more than 3%, and the employee has to make it up to 8%, or both of them could increase their contributions. There is a degree of flexibility here.
When an employee has a personal pension scheme, the employer may decide to contribute, but this is voluntary, not a legal obligation.
Tax relief on an employee’s pension contribution is reclaimed similarly to sole trader pension contributions; basic rate tax is automatically reimbursed with any additional relief noted on your annual tax return.
Limited company contributions
Where an employer makes contributions to an employee’s pension, these payments are made before the deduction of corporation tax and national insurance. On the one hand, the employee receives a gross contribution from the company; on the other hand, the company is effectively saving on corporation tax and national insurance by reducing the overall level of profits.
The tax affairs of limited companies are more complex than those of sole traders, but pension contributions are an interesting area of discussion.
Setting up your own limited company
While opinion is split as to the “right time” to switch from a sole trader to a limited company, there are tax considerations other than pension contributions to consider. At this point, it is essential to note that a limited company is legally a “person” in its own right and, therefore, separate from the owner. Consequently, you could set up a limited company to run a business where you were the only employee – the company would be your employer.
In this situation, you can make pension contributions while accepting additional company payments. Typically, employer payments would be restricted to annual profits in that year. However, where pension contributions create or increase a loss, this can be offset against corporation tax paid in the previous year – or carried forward.
Offsetting profits, reducing tax
Those who set up their own limited company, effectively becoming an employee, will often use pension contributions to reduce or eliminate annual profits. As pension contributions are deemed a business expense, they are offset against profits while the contributions are paid gross into your pension. You will need to consider the company’s finances and the contribution level compared to your annual salary, but this may be an option.
Where HMRC deem a pension payment excessive compared to your annual salary and role within the company, they may refuse tax relief. This is where it starts to get complicated, and it is vital to take professional financial advice.
Salary sacrifice
As an employee, there may also be an option to undertake what is known as a salary sacrifice. This may be useful where an increase in your salary would have significant tax consequences. Rather than, for example, moving into the next tax band, you could discuss a salary sacrifice with your employer. What would this mean for you?
Suppose you were in line for an additional £10,000 per annum, which would have significant tax consequences. You could effectively “give up” the salary increase in exchange for an enhanced employer pension contribution to the tune of £10,000 gross per annum. This would see your pension fund grow, creating a corporation tax saving for the company and saving you additional tax. The main downside would be cash flow; these additional funds would not be available until you were eligible to draw down on your pension scheme.
Looking at the broader picture
When focused on pensions, for many, it may look relatively cut and dry; as a sole trader, you will be the only contributor to the pension. When you are an employee with a pension workplace pension scheme, your employer is obliged to contribute a minimum of 3% (8% combined between employer and employee) of your gross annual salary.
As the owner of a limited company, you can offset taxable profits by enhancing your pension contributions. However, this would affect the company’s cash flow and funds for investment going forward.
Planning for your retirement
Pension contributions constitute a significant element of your retirement planning, but there is also much more to take into account. You must consider your current and required funding, living expenses, additional assets, investments and potential tax liabilities. Various tax reliefs and tax rebates may be available across the company and individual scenarios, which need to be looked at in more detail. It is always challenging where tax is involved, especially the merging of company and personal taxes!
Conclusion
When focusing on the subject of sole trader pension contributions and those made by employers, the situation looks more straightforward on the surface than it is when you dig a little deeper. It is also critical that you consider your broader financial situation, current and prospective, as well as your goals and aspirations in the short, medium and long term. Pensions in isolation can be relatively complicated, but when you also draw in company finances and various tax offsets, any simple mistake could be costly further down the line.
If you are considering your pension options, please call, and we can discuss your situation in more detail.
