Is It Worth Paying into a Pension Scheme?
THE ARGUMENT
This is a very interesting question. It is also a very important question as your future financial welfare depends on making the right decision. In all our years in practice, we have discovered that many clients do not wish to pay into a pension scheme. The reason behind this is because they believe that they can do better through investing on their own (clever investment) or investing in property etc.
Are they right in their approach? And where does the truth lie?
They surely have a case in that most pension plans charge administration charges and commissions- some more than others that can shrink the fund. Also, they can be hit by bad administration that can affect investment performances. And one cannot avoid recalling into memory the famous pensions mis-selling scandal that broke in the 90s. In addition, there is talk in the air that the so far tax-free lump sum taken up on retirement will soon be no tax- free.
Although there are significant tax advantages in paying contributions to pension plans, the subject must not be examined only from the tax point of view. There are other important considerations such as the need to provide for retirement, investment performances etc. We will talk about the advantages in detail next.
But first, we should state some basic facts.
What is a pension plan?
It’s putting some part of your salary and earnings in general away for your retirement.
How do pension plans work?
INTRODUCTION
There are various types of plans, the most widely spread of which are:
- Plans set up by employers and into which employees (and sometimes their employer) make regular contributions at levels determined by legislation. Employees can make top up contributions to AVCS (additional voluntary contribution schemes) if the payments to the employer scheme are lower than the maximum allowed by law. The part of the salary that goes into the pension fund is not subject to income tax but employer’s and employee’s National insurance is charged on it.
- Plans for the self-employed people and employees without access to occupational schemes, where regular payments are made at levels determined as a percentage of their earned income (i.e. salaries or taxable business profits) and which vary with age. Contributions to personal pension plans and AVCS are made net of basic rate of income tax. This means that for every £78 you pay into the scheme, the Inland Revenue puts the balance £22 into the fund. You get that even if you are a non-taxpayer or you only pay tax at 10%. If your income (including capital gains, by way of concession by the Revenue) falls within the 40% bracket, you get the extra tax relief by making a claim in your self-assessment tax return.
By the way, if your contributions to your personal pension plan haven’t decreased from 6/4/1 (date after which contributions are paid net of basic rate of income tax), get on to your insurance company and ask why, as you might have been overpaying all this time.
- Stakeholder plans, which are a version of personal plans and which have extremely low charges are open to employees (if their earnings from employment is below £30,000 or if certain other conditions apply), to self-employed persons as well as to persons who don’t have any earnings (e.g. children). The latter can make contributions up to £2,808 per annum (the government will add a further £792 to their pot).
With personal plans and stakeholder plans, 25% of the pot can (optionally) be withdrawn tax-free on retirement whereas the balance is used to buy an annuity that will provide regular pension benefits in retirement. Of course, the drawback is that, the part of the capital fund that buys the annuity is lost and goes to the insurer when you die. And, what about the low annuity rates currently on offer, which reduces the pension benefits?
For occupational schemes, the bulk of the fund must be used to buy an annuity on retirement
Let us take a look now at ways to save tax through the use of pension plans:
THE USE OF CERTAIN PLANS TO SHELTER CAPITAL ASSETS AGAINST CAPITAL GAINS TAX AND INHERITANCE TAX
Certain plans can be useful tools towards avoiding capital gains tax and inheritance tax while helping to mitigate business taxes prior to retirement.
The directors of an unquoted trading company (or a sole trader) can set up a SIPP (self-invested pension plan). These schemes allow control over the investment policy of the plan rather than give control to an insurance company. Those plans are permitted to invest, among other, in commercial property, which can, subsequently be used by the company, instead of borrowing by the company to buy the property.
The company will then be able to deduct commercial rent charged by the plan and repairs as tax allowable business expenses whereas the profit made by the scheme will be exempt from income tax. On top, when the owners of the business retire and the business and property are finally sold, the capital gain on the property owned by the pension plan is exempt from capital gains tax. (This is because income and capital within the pension fund are respectively exempt from income tax and capital gains tax). Please note that the capital gain arising on disposal of the property would have been taxable if the asset were held either by the director or by its company.
Furthermore, on retirement, the director can withdraw 25% of the plan fund tax-free. With the balance, up to the age of 75 he can carry on self-investing instead of having to buy an annuity. If he dies before the age of 75, the value of the SIPP is exempt from inheritance tax. If the asset were held personally by the director and used for the trade of the company, it would qualify for 50% exemption from inheritance tax (under business property relief). If the asset were owned by the company, the shares would qualify for 100% exemption from inheritance tax (under business property relief).
As an alternative form of this, the company may sell the premises it already owns to the plan, so that the benefits described above can be had. In this case though, the VAT implications must be considered. If the property is below 3 years old, the company must charge vat on the sale. How to avoid the VAT is outside the scope of this article.
SAVE TAXES WITHOUT JEOPARDISING PENSION ENTITLEMENT
Directors who already have personal pension plans can continue making annual contributions to those schemes even if they don’t pay themselves any salaries in a year, so that they avoid payroll taxes (income tax and national insurance contributions, both employee and employer’s). Instead, they choose to get dividends from their shares in the companies.
How does this work?
As it is known, dividends don’t count as earnings for the purpose of assessing net relevant earnings out of which pension plan contributions can be made in a year. Luckily, though, the law says that relevant net earnings made in one year can be used to justify contributions for up to five years afterwards. If you are going down this route, you might as well give yourself a salary before 6/4/3 to escape the 2% hike in national insurance contributions.
Another solution to alleviate the problem is for the director to take out a stakeholder plan. That way, he can make annual contributions up to £3,600 with no need for any relevant earnings at all and also enjoy low charges (up to 1% as opposed with some plans that cost the sky). £300 per month is not a small amount for a lot of people.
THE USE OF PENSION PLANS TO REDUCE BUSINESS TAXES
In general, pension contributions are an allowable business expense against corporation tax profits.
It might be worth considering sacrificing a pay rise in favour of increased employer contributions to an occupational pension scheme. Employer’s contributions to the company pension plan not only are not subject to national insurance contributions, but they also qualify 100% as a deduction from company profits to reduce corporation tax. So, both the employee and the company would save on NI by diverting the pay rise for the employee’s own long-term benefit rather than the government’s.
Another solution towards reducing the company’s corporation tax bill is to use a stakeholder plan to extract profits from the company tax-free. For example, if the director’s wife is a company employee on a low salary (e.g. £4,500 p. a. to avoid payroll taxes), a stakeholder pension plan can be set up for her benefit. The company will pay in it an amount up to £2,808 (the government will add another £792). This will also qualify as a company tax allowable business expense to reduce corporation tax. Every little bit helps!
ANY ALTERNATIVES?
Okay then, so you have decided not to take up a pension plan. What’s the alternative? Well, think about it! You want a product that gives you income tax- free, both whilst being invested and when you receive it. Welcome to the world of ISAs!
The advantage over pension plans is that you can have access to your funds anytime you want (as opposed to pension plans, with which you can’t touch your money until retirement).
With an ISA there is no restriction as to the amount you can take – remember with pension plans there is a maximum 25% tax-free lump sum on retirement. This can be extremely handy in cases of emergency when you need to have access to your money early.
Moreover, with ISAs the income is taxed before going into the fund, whist, on the contrary, pension benefits are taxed as earned income (because, remember, pension contributions are tax- free). Wouldn’t you prefer paying the tax now rather than on retirement when you may need every penny to live on?
THE CONCLUSION
We are not suggesting that you should turn down employer ‘s pension plans into which the employer pays for your pension. By all means don’t turn the offer down! But if you don’t have access to an employer’s scheme or if you are a self- employed person, you might as well know that there are other prepositions in addition to pension plans. You may decide to use an ISA to supplement the pension from your pension plan.
Thank you for taking the time to read this Article. I hope you’ve found it useful. If you have, please drop me an email and let me know what you think.
You can email me via contact form on our website at http://www.taxadviceuk.com.
Alternatively, you can read there a series of other full length articles that present the complete picture on a variety of interesting topics.
If you would like to know how to save tax and make sure that more of your hard earned cash stays with you to expand your business and increase your profits, we have a Free Special Report addressed to small businesses either starting up or already in business. This Exclusive Free Special Report is available automatically when you subscribe to our regular series of Free Newsletters on finance advice and tax planning by visiting our subscription area on our website. It is complied from real life situations dealing with small business tax affairs for over 10 years and it is loaded with down-to-earth advice and practical, understandable examples.
Demetris Savva FCCA
Constantine Savva
Chartered Certified Accountants
March 3, 2003
LEGAL NOTICE
Whilst every care has been taken in the preparation of this article, the author cannot accept responsibility for any errors or omissions. Proper professional advice should be taken at all times.
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