Technical Insight
Profit extraction: why employer pension contributions deserve a second look
Employer pension contributions can offer SME business owners a tax-efficient alternative for extracting profits.
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When owners of small and medium sized enterprise (SME) companies choose how to take their profits, there’s a strong argument in favour of pension contributions.
While dividends may still be king when it comes to extracting income from a company, changes in how they are taxed may encourage more directors who don’t need the income for day to day living to extract profits using employer pension contributions instead. Since its introduction in April 2016, the dividend allowance has been reduced three times, now standing at just £500, one tenth of its original level.
Tax efficient extraction
Taking profits as salary is more expensive than taking it as a dividend, even with the reduction in the dividend allowance. For a higher-rate taxpayer*, the combined effect of corporation tax at 19% and dividend tax of 35.75% will still yield a better outcome than paying the same amount as salary, which needs to account for income tax at 40% plus employer national insurance (NI) of 15% and employee NI of 2%.
However, pension contributions remain more tax efficient. An employer pension contribution means there is no employer or employee NI and is normally deductible against corporation tax if it is incurred wholly and exclusively for the purposes of the employer’s trade or profession. This can create a valuable combination of corporation tax relief and NI savings.
And of course, with modern flexible pensions, directors aged 55 or over can access their pension benefits as easily as salary or dividends, although this age limit will rise to 57 from April 2028 for most pensions. With 25% of the pension pot normally available tax free, this can be a tax efficient option – especially if the income from the balance can be taken within the basic rate tax band. Whilst income doesn’t need to be drawn at the same time as accessing tax-free cash, remember that taking drawdown income will trigger the Money Purchase Annual Allowance (MPAA), restricting future saving options.
In practice, many business owners may pay themselves a small salary, building up state pension entitlement without triggering employee NI (some employer NI may be payable depending on availability of employment allowance). They may then take the rest of their annual income in the form of dividends. But what about profits more than their income needs?
Comparing the options
The table below compares the net benefit ultimately derived from £40,000 of gross profits to a higher-rate* taxpaying shareholding director in the 2026/27 tax year (assuming the dividend allowance has already been used, and all dividend income falls in the higher-rate tax band).
| Bonus | Dividend | Pension | |
| Company profit | £40,000 | £40,000 | £40,000 |
| Corporation tax @ 19% | £0 | £7,600 | £0 |
| Employer NI | £5,217 | £0 | £0 |
| Value to director | £34,783 | £32,400 | £40,000 |
| Director’s NI | £696 | £0 | £0 |
| Director’s income tax | £13,913 | £11,583 | £0 |
| Net benefit to director | £20,174 | £20,817 | £40,000** |
* examples based on income tax rates applicable to England & Wales **pension is subject to income tax when drawn, after 25% tax-free where available Lump Sum Allowance
Adviser tip
The business should consider whether it needs to retain profits in the business to deliver further growth or expansion, or whether they can be distributed via bonus, dividend, or as a pension contribution?
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From the table above we can see that the pension contribution produces the strongest tax outcome with dividends a slight improvement on bonus (or additional salary). However, which option to follow will depend on the client’s objectives and circumstances.
There are a number of factors to consider:
- The timescale involved until the client needs access to the money. For older directors (over 55, or from April 2028 over 57) this is less of a concern since they could access their pension fund immediately.
- HMRC’s view on whether any profits paid as pension contributions would be treated as being ‘wholly and exclusively for the purposes of its trade’ such that they qualify as a deduction for corporation tax purposes.
- Whether funding a pension is a priority for the client.
- Will the forthcoming changes to salary sacrifice arrangements, scheduled to come into effect from April 2029, result in a normal employer contribution providing a better solution than by taking the profits as bonus and contributing it via salary sacrifice.
- How the client who might favour a longer-term investment could be impacted post April 2027 when most pensions will be included in the estate for inheritance tax (IHT) calculations.
- The level of company profits and director’s income as these will affect the calculations depending on the rates of corporation tax and income tax that will be applied.
- The pension contributions that could be made, taking account of the client’s available annual allowance and any carry forward of unused allowance from the previous three tax years.
- What effect will the solution have on the client’s income tax bracket and, where a dividend is taken, will a personal contribution to a relief-at-source pension plan allow some or all of the dividend payment to escape higher rates of dividend tax, by extending the basic rate income tax band?
Case study
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Joe is 56, a director of an SME, with the following sources of income. He has £80,000 profits to extract from the business and he holds an existing SIPP although it has not received any contributions for several years. His income for the year is:
| Salary | £175,000 |
| Rental income | £18,000 |
| Dividend income | £10,000 |
Joe has a number of options
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Option 1 – Pay Joe a bonus or additional salary
The £80,000 will provide taxable income of £69,565 plus employer’s NICs of £10,435. Joe will then incur 45% income tax and 2% employee’s NICs leaving him with additional net income of £36,869
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Option 2 – Pay Joe a dividend
Assuming a corporation tax rate of 19%, £15,200 will be paid in corporation tax. This leaves £64,800 available as a dividend payment. This will be subject to additional rate dividend tax @ 39.35% leaving Joe with additional net income of £39,301
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Option 3 – The company makes a pension contribution to Joe’s pension
Firstly, this contribution will result in Joe becoming subject to the Tapered Annual Allowance (TAA). The pension contribution is added to his income to calculate his adjusted income. This gives Joe a total adjusted income of £283,000. His Annual Allowance is tapered by half of the excess above £260,000 giving him a TAA of £48,500. If Joe has at least £31,500 of unused annual allowance available through carry forward, the full contribution could be made without an annual allowance tax charge. If he does not, the excess £31,500 will incur an annual allowance tax charge of 45% leaving a net value to Joe of £65,825. Even in these circumstances, the pension contribution may still compare favourably with the salary or dividend alternatives. If Joe wishes to draw the full £80,000 immediately, he could take £20,000 tax free and pay income tax on the remaining £60,000, giving him a total net amount of £53,000.
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Adviser tip
If a client wants to maximise their future contributions they need to consider when and how they access their pension benefits, as their ability to make future contributions to defined contribution pensions could be restricted by the MPAA, currently £10,000.
Longer-term considerations
When considering how to extract wealth from a company, directors should also take a long-term view that extends beyond immediate tax outcomes and focuses on the eventual value retained by themselves and their family. From 6 April 2027, most unused pension funds and death benefits will be brought into the scope of IHT and included when calculating the value of an individual's estate – removing a current advantage.
Even after these changes, pensions can still retain significant long-term advantages. Pension funds continue to benefit from a tax-advantaged investment environment, allowing growth largely free from UK income tax and capital gains tax. In addition, any remaining pension benefits may pass free of income tax depending on age at death and the beneficiary's circumstances. This combines to compare favourably with wealth accumulated through salary or dividends and held in taxable personal investments. Additionally, salary, dividend or pension wealth all enable clients a range of gifting strategies to help offset IHT.
Directors should therefore consider pensions as part of an overall strategy that balances retirement objectives, family wealth planning and future inheritance tax exposure, rather than viewing the decision solely through the lens of current-year tax efficiency.
Conclusion - Where this leaves advisers
Pension contributions can produce a good outcome provided profits are genuinely surplus to the client’s income needs, although pension contributions will not be the answer for everyone and advisers need to consider each case on its own merits. Whilst pension contributions can offer attractive tax savings these need to be weighed up against the client’s need to access the funds, their future plans, and the impact of changes to inheritance tax legislation from April 2027 when the value of most pensions will be included in the estate.
With IHT treatment changing, see our briefing on Pensions and IHT - From 6 April 2027 for details of how pensions will be treated for IHT purposes where death occurs on or after 6 April 2027.
For further information and queries, please call one of our distribution team today, or refer to our TechVoice resources.
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