Contractors paying basic rate tax and who are starting a pension to mitigate the impact of the Dividend Tax changes coming into force from 6 April 2016 should take action now.
According to Angela James of Contractor Wealth, a financial adviser who specialises in contractor financial advice, there are three key reasons why contractors need to talk to an adviser now.
“Setting up a pension can take several months, and as tax yearend approaches, the best contractor advisers will be incredibly busy. Plus contractors can benefit from this year’s tax-free pension allowance if they set up the pension in the 2015/16 tax year.”
Start a pension now to use the 2015/16 tax-free allowance
Historically, and up until 6 April 2016, contractors who only pay themselves a salary and dividend within the basic rate tax band have not paid income tax on their dividend. That all changes in April 2016 when the Dividend Tax changes come into force and basic rate income will be taxed at 7.5%, potentially costing contractors many thousands more in tax.
But there are strategies contractors can use to mitigate the impact of the Dividend Tax changes and to ‘use up’ large cash piles that have accumulated in their limited company.
James explains: “Contractors can set up a company pension scheme that enables their limited company to make pension contributions of up to £40,000 each year [correct at the time of writing]. These contributions are paid out of a contractor’s gross fees, so there is no Dividend Tax charge.
“By setting up a pension in the 2015/16 tax year, contractors can use their £40,000 tax free allowance to reduce any large cash surpluses that they would otherwise withdraw as a dividend and pay extra tax on.”
James notes that taking action now leaves a £40,000 tax free pension contributions allowance for the 2016/17 tax year and going forward that a contractor can use to save tax efficiently for a comfortable retirement and mitigate their Dividend Tax costs.
“Contractors who already have a pension can carry forward unused allowances from previous years to benefit from additional tax free pension contributions. Contractors who do not have a pension cannot do this,” she adds.
Don’t leave setting-up a pension until the last minute
As well as ensuring they use their 2016/17 pension allowance, contractors should take action now simply because of the ‘logistics’ of setting up a new pension scheme. James notes that financial advisers have a duty of care towards their clients and have processes to follow that can take time.
“The process of determining a contractor’s financial requirements in retirement, considering the optimal pension scheme for their needs, working out the tax position and completing all the paperwork to get the contractor’s limited company pension scheme set up can take several months,” continues James.
“If they are putting large sums of money into an investment, then contractors also need to take the time to understand what this might give them in the future.
“Furthermore, good quality financial advisers who are contractor specialists will always be very busy as yearend approaches, ensuring that their existing contractor clients are making best use of tax allowances. That may not be the best time to start a new pension.”
Husband and wife-owned business will be hardest hit, but beware pitfalls
Because the Dividend Tax changes impact on individual shareholders and not on the contractor limited company, it is companies that are co-owned by husband and wife teams that will have to pay the most extra tax from April 2016.
“Two spouses can also make use of pensions to mitigate the impact of the Dividend Tax changes,” highlights James. “However the contributions must be consistent with the contribution that the spouse makes to the business or HMRC might take an interest.”
So, if a contractor is the fee earner, generating the bulk or all of the company’s income, then they can quite reasonably invest as much as they like into a pension each year, up to £40,000. If both spouses generate fees, then both can invest full into a pension.
“However, if one spouse only does some company administration and little else, then high pension contributions would be challenged by HMRC.”
James concludes: “For contractors who have yet to start a pension, the Dividend Tax changes are a great opportunity to both mitigate the impact of the tax changes and start building a pension pot to fund a comfortable retirement.”