In my view the optimal strategy for a limited company director is:
• Start with a personal payment which grosses up to your P60 salary.
• Then do a company payment in addition if you want to invest more.
Personal payments to a pension fund
To make the math easy we’ll consider a payment of £8,000 from a personal bank account to a pension fund. This is from after-tax income, so the Government will add £2,000 and the fund will then invest £10,000 for you. The limit on this is your gross P60 pay for the tax year, so it’s important to do the calculations properly if you’re going to get this tax relief.
The £10,000 now increases your basic rate tax band. So, for example, if you were going to declare £30,000 of dividends and pay dividend tax at a top rate of 7.5%, you can now invest £40,000 and still be in the 7.5% dividend tax bracket.
So the effective tax relief is 45% - you get 20% tax relief back from the Government into your pension, plus you pay 7.5% dividend tax on the extra dividends instead of 32.5%. This assumes you have enough profits to pay the extra dividends.
Company payments to a pension fund
Each individual has a £40,000 cap on pension payments for the 2020-21 tax year. Your company can pay this for you, or you could use a combination of personal and company payments. Suppose you’ve already done the £8,000 personal payment above. Your company can now make a payment of £30,000 into your pension fund.
This £30,000 is an allowable expense for corporation tax purposes, so the company pays less tax. The tax saving here is at 19%. Some accountants will argue that the saving is much higher. The argument here is that future dividends will now be £30,000 lower, and so as in the above personal pension example this will give a further saving of 25%.
But this extra saving depends on a lot of factors. It assumes high profits, but also a strategy of taking all profits out straight away as dividends. Perhaps other accountants have lots of clients like this, but in my own case this applies to less than half of limited company directors.