With the basic state pension currently a meagre £134.25 per week, setting up a pension is one of the best things you can do to secure your future.
But what’s the most tax-efficient way to pay into it if you’re a contractor working as a limited company? Should you make personal contributions? Or is it better to contribute through your limited company?
- Pension contributions as a company owner: what does the law say?
- Automatic enrolment – exemption for many small companies
- How much can you contribute to a pension?
- Should you pay personally or via your limited company?
- Summary for limited company owners
- Get a personalised pension illustration
Pension contributions as a company owner: what does the law say?
When you do business through a limited company, HMRC considers you an employee of your company. So if your salary exceeds the personal allowance — in 2020-21, this is £12,500 — your company has to deduct income tax via PAYE (Pay as You Earn). And if your salary is over the ‘secondary threshold’ — in 2020-21, this is £8,788 — your company has to pay Employers’ National Insurance. You (as an employee) will start to pay Employees’ National Insurance if you earn £9,500 or more.
More to the point, employers have to take part in automatic enrolment.
As a contractor working through a limited company, you can apply to the Pensions Regulator for an exemption (more on this in a minute). But if you don’t apply for the exemption, your company will have to set up a workplace pension. And it’ll have to deduct pension contributions from your ‘qualifying earnings’ and make contributions on your behalf.
Not exempt and haven’t set up automatic enrolment? You risk getting fined.
How much do you and your company have to pay under automatic enrolment?
Here’s the least you and your company would have to pay into a workplace pension as from 6 April 2019:
- Your company: 3% of your ‘qualifying’ earnings
- You: 4% of your ‘qualifying’ earnings
‘Qualifying’ earnings include your salary, but not dividend income. You’ll also get tax relief on your and your company’s contributions. If you pay tax at the basic rate of 20%, tax relief is paid into your pension automatically.
Auto-enrolment example calculation
Let’s say you take a salary of £8,788 and a dividend of £20,000. This means your ‘qualifying’ earnings for 2020-21 are £8,788 because dividend income doesn’t count.
Based on the latest automatic enrolment rates:
- A contribution of £281.22 (4% of £8,788, that is £351.52, less 20% tax) would be deducted from your salary
- Your company would pay £263.64
- You’d also get tax relief on your contribution at the basic rate of 20%. This would bring your contribution back up to £351.52
- So, in total, you and your company would contribute £615.16 to your pension in 2020-21
What if I don’t want to take part in automatic enrolment?
You can apply to the Pensions Regulator for an exemption from automatic enrolment if:
- You’re your company’s only director and employee (this is often the case for professional contractors).
- Your company has two or more directors, but none (or only one) have an employment contract and there are no other staff members
To apply for the exemption, you’ll need your letter code. This is a 10-digit code the Pensions Regulator will send you by post when you register your limited company. Key it into this online form, pick the reason for your application from the menu and your exemption should be approved immediately.
Getting the exemption has two main benefits.
Firstly, if you apply for the exemption, automatic enrolment won’t apply to your company. This means you won’t have to set up a workplace pension and make the minimum contributions.
At the same time, you can still set up and pay into a pension of your choosing.
How much can you contribute to a pension?
The simple answer is: as much as you like. The minimum thresholds under automatic enrolment are just that — minimum. Nothing stops you (and your company) from paying more into your pension.
The same goes if you get an exemption from the Pensions Regulator but still set up a pension.
Here, the minimum contributions don’t apply. So, you can pay as little or as much as you want, as long as you abide by your pension provider’s rules (some may have minimum contribution requirements).
That said, in either case, you’ll only get tax relief on contributions up to a certain amount.
Personal contribution limits
The most you can pay into your pension from your personal funds during a single tax year (in the UK, this runs from 6 April to 5 April) and get tax relief is the lower of:
- 100% of your salary
So, if your annual salary is £8,788, you can pay up to £8,788 into your pension in 2020-21 and get tax relief. You’ll have to pay 20% tax on any contributions you make over this amount.
And if your annual salary is £60,000, you’ll only get tax relief on the first £40,000 you pay into your pension. You’ll have to pay tax at your highest rate (in this case, it would be 40%) on the remaining £20,000.
Have a ‘threshold income’ of £110,000 or more a year and an ‘adjusted income’ of £150,000 or more a year? Your £40,000 a year allowance will be ‘tapered’. In other words, it’ll go down by £2 for every £1 you make over £150,000 until it hits £10,000 per tax year.
Adjusted income includes:
- Your taxable income, that is your salary, any income from investments and benefits-in-kind (a company car, for instance)
- All the pension contributions you’ve made throughout the tax year (both personal and through your company), including any tax relief
Threshold income, on the other hand, is your adjusted income less your pension contributions.
Limited company contribution limits
The salary threshold doesn’t apply to the contributions you make through your limited company. But the £40,000 per tax year limit applies.
Let’s say you pay £200 into your pension in 2020-21. Your company pays £40,000. In this case, you’ll be £200 over the limit. And you’ll have to pay tax on it.
That said, you can carry over any leftover allowance from the previous three years, as long as your company:
- Was registered in a UK-based pension during those three years
- Made at least as much profit as you want to contribute
Let’s say you set up a pension in 2016. Your company didn’t contribute anything in 2017, 2018, and 2019.
In 2020, your company could pay £160,000 into your pension, as long as it makes at least that much in profit during the year.
Pension contributions as a company owner: should you pay personally or through your limited company?
Paying into your pension through your limited company and paying from your personal funds both have their pros and cons. That said, paying through your limited company is usually more tax-efficient. And here’s why.
Personal pension contributions
The main advantages of making personal pension contributions are that:
- You get tax relief. If you pay income tax at the basic rate, this is paid automatically into your pension. If you pay a higher rate, you can claim additional tax back on your self-assessment tax return
- Unlike your company, you don’t have to justify your payments to HMRC (more on this in a minute)
But personal pension contributions have some big downsides.
You can only pay up to 100% of your annual salary into your pension
Dividends don’t count. So if you take most of your income as dividends (this is the most tax-efficient way to get paid through your limited company) you won’t be able to save much.
Of course, you could increase your salary in order to save more. But this isn’t tax-efficient.
Let’s say you decide to raise your salary from £8,788 to £13,000.
£8,788 falls within the personal allowance and is just under the lower profits threshold. This means you don’t have to pay income tax or National Insurance. You only pay dividend tax on your dividend income at 7.5%.
Raising your salary to £13,000 means you can pay more into your pension. But you’ll also have to pay:
- 20% basic rate income tax (in 2020-21, the personal allowance is £12,500, so you’d have to pay income tax on £500, which works out at £100)
- Class 1 Employees’ National Insurance at a rate of 12% over £9,500, which would amount to £420
As a result, you’d be £520 out of pocket. And that’s before you make any pension contributions. Your company would also have to pay Employers’ national insurance at 13.8%.
Personal contributions come out of your own money
If you pay into a pension with money from your salary, your take-home pay will go down.
What’s more, as a rule, you can’t withdraw money from your pension until you’re 55. So, if you pay into a pension with money from your savings, you’ll have to tie it up for a long time.
Paying into a pension through your limited company
The biggest advantage of paying into a pension through your limited company is that the salary threshold doesn’t apply. This means you can keep taking a salary of £8,788 a year and still be able to pay up to £40,000 into your pension every tax year.
Even better, your company’s pension contributions are allowable business expenses. As a result, you won’t have to pay Corporation Tax on them. Nor will you have to pay Employers’ National Insurance or deduct income tax from your salary.
That said, for the contributions to count as allowable business expenses, you’ll have to be able to prove that the company made them ‘wholly and exclusively’ for business purposes.
- Are reasonable.
- Don’t exceed the company’s annual profits. So, if your company turns a profit of £30,000 in 2020-21, £30,000 is the maximum the company can contribute to your pension that year.
- Are similar to the contributions your company is paying to others who are doing work of similar value. So, if another director is putting in as many hours and as much effort as you are, the company should be making similar pension contributions on their behalf too.
To pay into a pension in the most tax-efficient way possible:
- Apply for an auto-enrolment exemption from the Pensions Regulator. This will give you the flexibility to pay into a pension as much or as little as you like
- Pay into the pension directly from your company. This has the following benefits:
- You can pay up to £40,000 per tax year (as long as your company has made a profit of at least £40,000 that year)
- You’ll save on corporation tax and won’t have to pay employer’s National Insurance or collect income tax via PAYE, because the contributions are an allowable business expense.
- You’ll still be able to get paid tax-efficiently by taking the bulk of your income as dividends.
- We recommend you speak to a pension specialist so they can give you tailored advice based on your particular circumstances and needs. Please don’t rely on the information on our site as a substitute for professional advice.
You can also find more information on self-employed pensions on the following websites:
Find out more about limited company pensions
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