Entrepreneurs often assume that their business will make enough money for a comfortable old age – but what if things don’t go to plan? If everything is tied up in your company and it fails or doesn’t perform as well as you’d hoped, you could be left with very little in later life.

With uncertain trading conditions over the next few years a pension could be a useful way to spread your risk and it is an extremely tax-efficient method of extracting cash from your business. That’s because of the very generous tax relief that companies enjoy on pension contributions.

Corporation tax is currently 19%, so for every £100 your company earns as profit, you’ll pay corporation tax of £19, reducing the amount you can take as a dividend to just £81. But when the company pays £100 into your pension it effectively only costs £81 because of a reduction in corporation tax. 

Reducing income tax

In addition, a pension allows you to take a comparatively large sum without being liable for higher rate income tax. You could, for example, pay yourself a dividend of £50,000 and the company could pay up to the annual tax-free allowance of £40,000 into your pension. In fact, you can carry forward any unused annual allowance from the previous three years, meaning that the company could pay you a pension contribution of up to £160,000 in a single year, with a corresponding reduction in corporation tax.

For the contributions to be an allowable expense, they would need to meet the “wholly and exclusively” test. Essentially, this means the contribution must be commensurate for the work undertaken by the individual receiving the pension payment.

Simon Martin, Technical Connection Consultant at St. James’s Place, explains: “A typical company founder might say ‘my business is my pension’. That’s fine as long as the business is doing well. But if it goes badly, not only may your lifestyle be affected, but your retirement will be hit as well. If you have a pension, even if your company fails at some point in the future, the pension funds can still be held for your retirement. It’s a way of protecting yourself and your future.”

Tax-efficient extraction

Pensions are not the only way of taking money from your business tax-efficiently. You could, for example, pay yourself a dividend and the resulting income tax charge. The dividend could then be invested into a high-risk investment such as a Venture Capital Trust or an Enterprise Investment Scheme (EIS). Because the government wants to encourage such investments you would effectively enjoy 30% income tax relief.

If you are a higher rate tax payer (32.5%), for example, and you are paid a dividend of £10,000, you’ll owe £3,250 in income tax. However, if you then put your £10,000 straight into an EIS you’ll get £3,000 back in income tax relief. While there’s no real limit to how much you can pay yourself, there is an even higher income tax rate of 38.1% once you earn more than £150,000, so the gap between the tax you pay and the amount you get back increases.

Another advantage of removing unnecessary money from your company is that it removes it from the company’s balance sheet. That’s helpful if you claim Entrepreneurs’ Relief when you eventually sell the company because too much unused cash on the books can lead HMRC to conclude that it is not a trading company and refuse the relief.

Taking a pension and removing money tax-efficiently require careful planning and for many people it’s a good idea to seek professional advice.