A Director’s Retirement Strategy

A Director’s Retirement Strategy

Directors of their own limited companies enjoy the benefit of controlling their remuneration structure, which usually consists of salary, dividends and pension contributions for optimal tax efficiency and the latter to supplement retirement provision.

We often suggest that Director’s undertaking retirement planning consider a holistic approach, utilising various investment vehicles and allowances to ensure maximum flexibility. For some this will include retaining and investing company profits. For many, this will include pensions.

To date, some clients have been deterred from ‘over egging’ their pension contributions, due to what is perceived as excessive limitations imposed in drawing retirement benefits. However, Chancellor George Osborne’s initial announcement in his 2014 Budget and subsequent announcements since have changed all that.

From April 2015 we will see the implementation of Flexi-Access Drawdown, which is anticipated will see Income Drawdown become more mainstream. To date it has been regarded as suitable only for those with substantial funds in retirement and accepting of continuing investment risk. The benefit of this new regime is that previous limitations on accessing benefits over and above the 25% tax free cash limit will be removed. Any such benefits, whether taken as income or as ad-hoc lump sums will be taxable at the pensioner’s marginal rate.

So what does this mean for Director’s retirement planning strategies? Let us take a look at the various options assuming £40,000 gross profits netting down to £32,000 after 20% Corporation Tax.

For those that retain excess company profits, one option is to dissolve their companies upon retirement, liquidating any retained profit as a capital gain. Using Entrepreneur’s Relief, the 10% rate (up to £10m in 2014 /2015) will likely look attractive. £32,000 of net profits in the hands of the director would leave £28,800.

One should be aware that where a company becomes a ‘cash cow’, with retained profit superfluous to the activities of the business, such monies should be held in cash, as if a company is considered to be an investment company, an application for Entrepreneur’s Relief will almost certainly fail. Proximity to retirement will of course be a factor in the feasibility of this approach, which may result in a lost opportunity to achieve some investment growth.

One should also bear in mind that upon death, the company assets will be unlikely to attract Business Property Relief (BPR) and will fall within the value of the deceased’s estate. We strongly recommend that professional accountancy advice be sought if this approach is to be adopted.

An alternative would be to take the accumulated funds as dividends. However, these could be subject to higher rate Income Tax. For example, gross profits of £40,000 would equate to a net dividend of £32,000. Providing these are deferred until such a time as they can be drawn within the basic rate threshold, no further tax would be due. This may be attractive to those that can maintain their companies to and in retirement. However, this may not always be possible, therefore, assuming a higher rate Income Tax liability, this would reduce to £24,000. Similar to the retained profit option, these would potentially be subject to Inheritance Tax (IHT).

With the new rules on pension flexibility, a pension contribution, however, may now be a more favourable option. Not only will the pension contribution attract Corporation Tax relief, whilst held within the pension, it will be invested within a generally non-taxable investment medium. As pensions are exempt from IHT and will no longer form part of the individual’s estate, this will potentially save 40% IHT overnight.

If a Director is over 55, and opts to take benefits immediately, 25% of the fund would be tax free, with the remainder taxable at their marginal rate. Ignoring potential product and advice charges and growth, a £40,000 gross pension contribution would provide 25% tax free cash of £10,000. The remaining £30,000, if taxed at 40% Income Tax, would reduce to £18,000, thereby resulting in a net payment of £28,000 in the hands of the Director after an effective rate of tax of 30%. This is more beneficial when compared to the dividend option. However, if deferred until basic rate tax applies at 20%, the cash in hand position would increase to £34,000, i.e. £10,000 tax free cash plus £24,000, thereby resulting in an effective tax rate of 15%.

As illustrated, a little patience or forethought in planning results in a significant increase in the net return. Indeed the latter is one which is even better for the director than the retention of company profits or a dividend.

One should be cautious in adopting this approach, as once Flexi-Access Drawdown is triggered, a reduced contribution level of £10,000 will begin to apply. This is known as the Money Purchase Annual Allowance (MPAA) and replaces the normal Annual Allowance of £40,000 per annum.

As far as the company is concerned, retaining company profits or considering the dividend option costs £40,000, whereas with the pension contribution this would be £32,000, i.e. £40,000 at outset but with £8,000 of Corporation Tax relief.

If benefits are deferred and ultimately not drawn, on death before the age of 75, no IHT would be due and no Income Tax would be payable on any benefits drawn by the nominated beneficiary. Should death occur beyond age 75, whilst still no IHT is payable, any income or lump sums drawn by the recipient will be subject to tax at their marginal rate. This could be less than 40% IHT and for many no worse.

Let us take the opportunity to summarise the net returns of the various options from the £40,000 gross profits on their death before age 75: –

Option

No IHT Applies

40% IHT Applies

Retained after tax profit of £32,000 retained in the company and assuming no BPR

£32,000

£19,200

Retaine after tax profit of £32,000 drawn after 10% CGT leaving £28,800

£28,800

£17,280

£32,000 net dividend drawn with no further Income Tax liability

£32,000

£19,200

£32,000 net dividend drawn subject to higher rate Income Tax leaving £24,000

£24,000

£14,400

£40,000 pension fund before any benefits are drawn

£40,000

£40,000

£30,000 pension fund + £10,000 (25%) tax free cash drawn and retained

£40,000

£36,000

As stated, pension funds are exempt from IHT. Post April 2015, should the pensioner’s death occurs prior to age 75, then the funds may be drawn free of tax entirely and the figures above apply. However, in the event of death beyond the age of 75, the beneficiary of the pension fund will be subject to marginal rate of tax and the resulting figures are as follows: –

Option

Beneficiary’s marginal rate of 20%

Beneficiary’s marginal rate of 40%

Assuming 0% or 40% IHT –

£40,000 pension fund before tax free cash taken

£32,000

£24,000

Assuming 0% IHT –

£30,000 pension fund + £10,000 tax fee cash drawn and retained

£34,000

£28,000

Assuming 40% IHT –

£30,000 pension fund + £10,000 tax free cash drawn and retained

£30,000

£24,000

In summary, we can draw two clear conclusions.

The first is that for both the Company and the director, pension contributions are a very cost effective way of accumulating wealth for their retirement and one which does not require the continuation of the company.

Secondly, it can be seen that regardless of the marginal rate of Income Tax applying to potential beneficiaries or rate of IHT applying to the director’s estate, a pension contribution can be a very effective means of passing on their wealth to subsequent generations.

Clearly there are many considerations regarding a suitable approach depending upon one’s circumstances. Should you wish to discuss your own retirement planning in more detail, please do feel free to contact us.