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Employer contributions make up a significant portion of the total contributions paid to registered pension schemes. Here we look at the rules and limits for employers, employees and directors.
Employers have a key role to play in their employees’ retirement planning. As well as making their own contributions they must deduct employee contributions from pay, forward them to the scheme and now, under automatic enrolment legislation, assess eligibility and calculate contributions. Many employers were already playing an active role in this, but auto-enrolment has achieved enormous success in turning this into a formal obligation.
Employer pension provision is now a fundamental feature of employment, whereas it was previously an additional benefit mainly for skilled and professional roles and for those sectors paying at least moderate salaries. The workers that continue to miss out are very low earners, those with multiple low-paid jobs and the self-employed, but these are being considered as part of an overall review of automatic enrolment coverage.
As well as benefiting true employees, employer contributions can be utilised by company owners, who – whilst essentially self-employed – can pay themselves employer contributions as part of their remuneration package.
Employer contributions are paid gross, so they do not give rise to a personal income tax liability for the employee: this is equivalent to the receipt of tax relief on personal contributions. Furthermore, the payment of a contribution does not attract national insurance contributions (NICs) in the way that salary, bonuses, commission and certain taxable benefits do. This means that employer contributions are almost always more tax-efficient than employee contributions. But there is an exception to every rule: in this case non-income tax payers who get 20% tax relief under schemes that operate ‘relief at source’ despite not paying any income tax.
The national insurance (NI) saving is what makes salary sacrifice so appealing. The ubiquity of such schemes clearly demonstrates that employer contributions are, in the majority of cases, more tax-efficient than personal contributions.
Employer contributions are, in the vast majority of cases, deductible from taxable profit for corporation tax purposes. However, this is not particularly surprising given that they represent an inherent part of any reward package, and that staff costs are perhaps the most genuine trade expense. Other components such as salary and bonuses are similarly deductible from profit. But what sets employer contributions apart from cash rewards is their exemption from employer NICs. Employers are, therefore, usually quite happy for a significant component of their staff costs to be made up of contributions to staff pensions.
In most cases employers should not have any issues obtaining a deduction for corporation tax purposes for all employer pension contributions. HM Revenue & Customs Business Income Manual confirms that:
‘A pension payment by an employer is normally wholly and exclusively for the purposes of its trade’
Only in limited circumstances will a non-trade purpose have to be considered. Primarily, where the contribution is excessive relative to the employee’s duties; pension contributions for those connected to the business proprietor, for example, will be scrutinised more closely than others to determine if this is the case.
Company owners have a great deal of flexibility when it comes to drawing money from their business. They can choose from a number of remuneration options and can combine them in different ways, varying the weighting of each. Their main options are salary, dividends and pension contributions. As a general rule, from left to right, payment of the remuneration type becomes more restricted but more tax-efficient.
Company owners can pay themselves unlimited amount of salary, subject to the success of their business. Salary, however, is subject to the highest rates of tax and NICs of up to 47%. In addition, the salary incurs employer NICs, which company owners will need to factor in to determine how much a given component of remuneration costs them.
Mel owns Wheels Ltd and wishes to pay herself £100,000 from the company. To keep things as simple as possible she initially wants to look at the effect of paying the full amount as salary, dividends or an employer pension contribution. The net amount that can be extracted in each case is as follows:
There are a number of assumptions in each case: the salary column assumes Mel has no other income, so has her full personal allowance available; the dividend column assumes that she can pay herself this amount in dividends under HMRC rules; and the pension column assumes that she has sufficient annual allowance available to cover the full contribution and that she will be a higher rate taxpayer in retirement.
There are good reasons for a company owner paying themselves salary: one key reason is that paying enough salary to pay NICs (or qualify for NI credits) ensures entitlement to state benefits such as the new state pension. Because of this, many company owners pay themselves at least the NI primary threshold as salary.
Dividends are also a very popular part of the remuneration package, and with good reason as they do not attract employer or employee NICs. They must, however, be paid out of post-tax profits, which means there needs to be profit in the business that can be distributed, and they cannot be a deduction for corporation tax purposes. The company’s accountant should be consulted as to how much can be paid out in dividends, who will take into account HMRC’s restrictions on dividend-based remuneration strategies, which are in place to prevent company owners using the dividend route purely to avoid paying NICs.
But it is employer contributions that are usually the most tax-efficient component and, perhaps, the most under-utilised. A strategy that does employ them must take account of the annual allowance, however, particularly the tapered and money purchase annual allowances, as well as their inaccessibility before age 55. But, because of their tax benefits, they should form an integral part of the remuneration package, either via regular contributions or occasional large contributions to maximise available carry forward.
To determine the tax efficiency of different combinations of salary, dividends and pension contributions for a particular case, please refer to our Salary, Dividend and Pension Calculator.
Note: Scottish resident taxpayers have their own income tax rates and bands for 2019/20 which may affect the tax outcomes in our examples.
Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given.
Thomas Coughlan, Specialist in Pension Planning