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Contractor Doctor: Should I use ER or a pension to extract cash from my Ltd company?

Dear Contractor Doctor,

I have been contracting for a couple of years and I’ve been paying £2,000 into a pension scheme each month from my limited company. I was planning on building up a sum in my company to eventually take out when I retire using Entrepreneur’s Relief (ER). However, from further research it appears this might not be a viable option.

I’m not sure whether to continue to try and build up the lump sum within the company account and eventually attempt to withdraw it using ER, or whether to simply increase my pension contributions.

Should I use a pension or ER to tax efficiently extract cash from my limited company?

Thanks,

Stephen

Contractor Doctor says:

There are certainly advantages for contractors with either option, pension or Entrepreneur’s Relief (ER), but nobody can predict the future, and so it’s impossible to say whether or not these advantages will still be available as a contractor approaches retirement.

Ultimately, it may come down to a matter of control. Keeping money in the company means it will be available to the contractor closer to retirement. At this point, they may be better able to gauge what their best option is.

However, contractor pensions are currently a highly tax efficient way of saving, so not investing in a pension now means a contractor loses the tax efficiencies. In practice, contractors should seek professional advice when considering their options.

Pensions offer tax advantages, but they come at a risk

The current pensions regime can be extremely tax-efficient, and represents one of many potentially lucrative tax advantages available to contractors. The majority of pensions allow the individual to take 25% of their pension pot tax-free. If the contractor is in a higher tax band but plans to be in a basic band upon retirement - and the 25% tax-free withdrawal is available – pensions is certainly one way to go.

The only problem is there is no guarantee that these perks will be available to them in several years’ time when they decide to retire. The most recent Budget might have been a quiet one from a pensions perspective, but pensions remain a very tempting source of funds for the Chancellor and the rules surrounding pensions have changed many times over the last 20 years.

It’s also worth remembering that, whilst pension holders can invest cash tax free, some pension funds are very poorly managed and give a suboptimal return. Contractors paying into a pension will pay fees to a fund manager but will have no control over how the money is invested.

This is why good pensions advisers often recommend that contractors make use of pension schemes, but encourage them not to rely on them as their only source of retirement income.

Independent investments offer another alternative

Contractors who are confident enough may instead opt to self-invest to try and secure a greater return than both the tax-free element of pensions and the return of the fund over time.

Withdrawing money from the company rather than investing it directly into pension would incur corporation and income tax payments on dividends, but it does mean that the money is under the contractor’s control. The cost of getting control by paying all taxes is roughly the same as paying income tax on the money. So you miss out on all the tax relief options by not deferring control until retirement age. Hence a mixture of both strategies is advised, aligned with your long term financial plans.

Entrepreneur’s Relief (ER) on HMRC’s radar

ER has been a popular means of reducing the marginal rate of extracting large cash balances when closing down contractor limited companies following a career break or after retirement.

It allows a contractor to take cash out of their company upon its closure at a Capital Gains Tax rate of just 10%, as opposed to taking it out as income and paying up to 45% income tax.

However, ER has cost HMRC billions of pounds more than expected. This has been due in large part to the rise in ‘phoenixing’, where a company is liquidated to take advantage of ER, only for another to be immediately set up to replace it. There are rules that mean ER should not be available if a similar company is set up within 2 years of liquidation, but HMRC are concerned that this are not being followed.

So ER is now firmly on the radar of HMRC, which has implemented a new Targeted Anti-Avoidance Rule (TAAR) to clamp down on abuse of the scheme. As a result, this does create some uncertainty. If the new TAAR approach does not close down the abuse it might be removed or replaced by something less advantageous, meaning that in it's current form it might be a viable option for contractors several years down the line.

Contractors are best advised to wait and see

The contractor might be best advised to continue to retain money in their company for the time being. A few years before retirement they might consider dripping money out each year in order to stay within the higher, or even basic tax band.

For example, a contractor could have £300,000 in cash within their company and may plan to retire in ten years. Withdrawing £30,000 each year from the company keeps them within the basic tax threshold and ensures that they have a healthy portion of their savings available upon retirement.

Continuing to keep fee income within the company in the meantime to build a large cash balance ensures that taking advantage of ER remains a viable tax efficient option for the contractor at a later date, should it still be available.

However, the key thing to remember is that tax efficiency isn’t the only advantage of holding money within a limited company, as the contractor also retains complete control over what, how and when they pay. And that contractors should always seek professional advice before making such key financials decisions.

Published: 25 April 2016

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