With Corporation Tax set to rise from April 2023, it is a sensible time to re-explore one of the few remaining tax breaks left for limited company contractors – pension contributions.
The 2022 Autumn Statement saw a swathe of new tax measures announced by the Chancellor and some of these will have a direct impact on the UK’s contractors and freelancers.
Traditionally, all data points towards contractors being less likely to put money away for retirement than people who are employed full time.
Our latest contractor survey found that almost two thirds (59 per cent) of self-employed people in the UK are now paying money into personal pension pots.
This figure has risen from previous years, but it means there are still more than one in three contractors that aren’t putting money away for life after work.
This can be for several reasons, but often the security of having a cash buffer to fall back on in between contracts can be a big factor. This can mean that many contractors have built up sizeable lumps of money that – when they decide to hang up their contracting boots – can be used for retirement.
Here, Joanne Thorne, Technical Compliance Manager at SJD Accountancy discusses some of the key things to consider when it comes to pensions for limited company contractors:
Pension Contributions
Most pension schemes will accept both company and personal contributions, but you should check that any scheme you have set up can also accept employers’ contributions, if you wish to contribute directly from your limited company.
Personal contributions are normally capped at the lower of the salary being paid and £40k, and so limited company directors often find that being able to top up their pension pot with company contributions can be really beneficial.
This is due to the corporation tax relief that can be obtained for eligible company pension contributions.
Corporation Tax
Corporation Tax will increase to 25% in April 2023, despite hopes that it would have been kept at the current level of 19%, as referenced by former Chancellor Kwasi Kwarteng during his Mini Budget.
The 25% corporation tax rate only applies if a company’s profits exceed £250,000. Companies whose profits are between £50,001 and £250,000 will be subject to tapered relief, whereas those with profits that fall below £50,000 will remain at 19%.
When it comes to corporation tax, employers’ pension contributions are important because they can reduce corporation tax costs. Any pension contributions come from pre-taxed company income, and because employer contributions are classified as ‘allowable expenses’, it’s possible to claim tax relief.
For the 2022/23 tax year, for every £1,000 a company earns as profit, it will pay Corporation Tax of £190 reducing the amount available as a dividend to £810.
Paying £1,000 into a pension pot therefore effectively costs the company only £810 due to the reduction in Corporation Tax payable, so it’s a very tax efficient way for Limited Company Directors to manage their finances.
This example is based on companies with small profits (under £50,000) as the main rate will be 25% in 2023 for companies with profits over £250,000.
Arguably, it is one of the last few remaining tax breaks available because of further changes announced to the dividend tax allowance threshold, which is being reduced from £2,000 to £1,000 in April 2023 and cut again to £500 in April 2024.
The carry forward rule
Now that we’ve made the case for pensions being a tax efficient option for Limited Company Contractors, it’s important to highlight the carry forward rule. This allows the option to utilise unused pension allowances from previous tax years.
It works because all contributions will be tax-free as long as they do not exceed the annual allowance, which is currently capped at £40,000 for the 2022/23 tax year. It was the same in the previous tax year.
The rules allow you to make use of annual allowances that have not been used in the previous three years, provided that you were a member of a registered pension scheme for those years.
This means that any contractor in the position of having sizeable cash reserves but who hasn’t used these allowances to the maximum could make use of them.
This annual allowance only applies to pension savings made to UK registered pension schemes, or to overseas schemes where the individual qualifies for UK tax relief.
You cannot carry forward unused allowances from any tax year where you were not a member of at least one UK registered pension scheme, or a qualifying overseas pension scheme.
Your pension provider, or financial adviser will be able to help you understand your options here, as well as ensure that you are not exceeding the pension lifetime allowance, which is currently set at £1,073,100.
In addition, for pension contributions to be deemed eligible for payment and tax relief, it can help to add them to any contractual agreement you have in place for remuneration payments to a director or employee.
Where there is a contractual obligation to make a pension contribution as part of a remuneration package, HMRC may be more likely to consider it as an allowable expense, and so it should receive the associated tax relief, which is especially important if your company is no longer trading, or you are looking to close it down.
Getting the balance right with pension contributions
It is also important to consider that although pension contributions are a great, tax efficient way of extracting funds from your limited company, and looking after your future financial requirements, the money invested could potentially be locked away for a number of years.
Getting the balance right of having access to funds that you may need to use in the short-term, while building for the long-term future is therefore really important.
Some pension schemes will allow lump sum contributions, allowing you to judge at the end of the year what you have available to put away, meanwhile others are set up for set monthly contributions.
Only those regulated to provide investment advice, such as pension providers, or financial advisors are permitted to provide specific pension advice, though your accountant can certainly help you to understand the basics, such as helping you to understand what available profit you may have in your company to be able to contribute.
It’s important to consider all your options when it comes to effective tax planning as individual circumstances will dictate the best course of action. But with so much change in terms of government policy, it has never been more important for the self-employed to think carefully about their tax planning strategies.
Find out more about contractor pensions
Find out more about tax relief on pension contributions. To get in touch with a specialist IFA, click here.
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