What is a SIPP?
Self-Invested Personal Pensions (SIPPs) are a form of pension that, unlike traditional pension funds, provide the owner of the pension pot control over where their money is invested and allow them to decide what type of investments they want to make.
Please note: As we aren’t financial advisors, we aren’t able to recommend any specific products or pension providers, however, what we can do is explain the tax implications and rules on SIPPs. Read on below to find out more about SIPPs.
- Annual Allowance: £40,000
- Lifetime Allowance: ~£1m
- Employers contributions made via a limited company are a tax deductible expense.
- Sole Traders cannot make employers contribtions to themselves - these are treated differently
- Can withdraw 25% from your SIPP as a tax free lump sum upon retirement (55 years old at the earliest)
Annual Allowance for Pension Contributions
Each year individuals are allowed to contribute 100% of their relevant earnings, up to a maximum of £40,000 into a pension, that can qualify for tax relief. Contributions above this limit will have tax relief removed from them in the form of a tax bill, called the "annual allowance charge".
Relevant earnings include your salary, but do not include investment income such as that from property or dividends. So if you have a basic salary of £12,500 per year and the rest of your income is received through dividends, you can only make £12,500 worth of personal pension contributions.
Relevant earnings do not apply to employers contributions (although the maximum tax relief is still capped at £40,000), so if you are paying into your SIPP via a limited company (more on that below) you can still contribute up to £40,000 per year without incurring the annual allowance charge.
Lifetime Allowance for Pension Contributions
Currently the lifetime allowance for each individual is: £1,073,100
Please note that we will round this down to the nearest million for the rest of this article!
As this is a lifetime allowance, it means that an individual can only receive tax relief up to that amount over their lifetime.
Despite the lifetime allowance being so high, the annual allowance still applies each year. As the annual allowance is £40,000, this means that you would need to make your maximum yearly contribution for 27 years in order to fully utilise your lifetime allowance at the current level.
If you want to retire in the most tax efficient manner possible, you would need to contribute £40,000 per year from the age of 28 until 55.
SIPPs for Limited Companies
Making employer contributions to employee pensions is a tax deductible expense. This means that making payments into employee pensions will reduce your trading profit and your corporation tax bill.
Therefore if you own a limited company, you can make payments into a SIPP, which will reduce your profits and your corporation tax liability. As this money goes straight into your pension pot, you don't pay income tax on it either. Instead, you will pay tax on the income when it is drawn from the pension pot after you retire.
There is no cap for how much an employer can pay into an employees pension, however, as the annual personal allowance for pension contributions is £40,000, it means that if an employee receives more than £40,000 (as a combined total of personal and employer) in a tax year, they may be subject to personal tax charges.
The current corporation tax rate is 19%. This means that you can reduce your corporation tax bill by £7,600 (£40,000 @ 19%) each year per employee that is paid their maximum annual contribution.
This can be incredibly tax efficient if you are looking to save money for retirement.
Note: In each example we have assumed that your company has made £10,000 in profit and you are withdrawing all of it from the company. We have also assumed that you are a higher rate taxpayer and have already used your entire dividend allowance.
Company profit paid as dividends
If your limited company makes £10,000 in profit it will incur £1,900 in Corporations Tax, leaving the balance of £8,100 to be paid in dividends. You will then pay income tax of £2,632.50 (32.5% of £8,100) on these dividends.
In this scenario you will be left with £5,467.50 in your personal bank account, which you can spend on whatever you want.
Company profit paid as employer pension contributions
If your limited company pays £10,000 to you as an employer pension contribution, it reduces your company’s profit by £10,000 and therefore would not be subject to corporation tax.
The full £10,000 would go directly into your pension, where it will have the opportunity to grow tax-free until you reach retirement.
On top of this, as the money is not being paid to you as a dividend or salary, you will not have any income tax to pay on it straight away. Although please note that you will have to pay tax on the pension later in life, this is explained in more detail below.
Although this is tax efficient, the drawback is that you are unable to spend the money until you retire.
SIPPs for Sole Traders
A sole trader can take on employees, however, they cannot employ themselves. This means that although they can make tax-deductible employer pension contributions to reduce their profits, they cannot make these contributions into their own SIPP and benefit from lower trading profits.
This means that in general, making pension contributions is not as tax efficient for sole traders as it is for limited companies. However, sole traders still will receive income tax relief on any pension contributions that they make.
Income Tax Relief on Pension Contributions
Income tax relief is given to individuals who make pension contributions in the form of extending your personal tax bands by the amount of contributions made.
This means that if you contribute £10,000 into your SIPP in a tax year, then your basic rate tax bracket will extend by £10,000 from £37,500 to £47,500 and your higher rate threshold will extend from £100,000 to £110,000.
For example, if you usually earn £70,000 per year your income tax calculation will look like this:
£12,500 @ tax free personal allowance (NIL) = 0
£37,500 @ basic rate (20%) = £7,500
£20,000 @ higher rate (40%) = £8,000
£70,000 Total income tax = £15,500
However if you have made £10,000 of personal pension contributions in the year then your tax calculation will be as follows:
£12,500 @ tax free personal allowance (NIL) = 0
£47,500 @ basic rate (20%) = £9,500
£10,000 @ higher rate (40%) = £4,000
£70,000 Total income tax = £13,500
This means that by contributing £10,000 to your pension you will have reduced your income tax by £2,000.
How are pensions taxed?
Once money is invested into a pension pot it is shielded there tax free until retirement. This is incredible for growth as it means that any gains will be made on a larger sum of money, which means faster and greater growth overall.
When you reach retirement age, you are able to draw down on your pension - It is at this point that you start to pay tax on your pension.
In general, pensions are taxed as if they were income when you receive them, meaning that you will pay tax on them similar to if they were a salary.
Please note that you will not suddenly have to pay tax on the entire amount in the pot, or on any subsequent gains made within it, you will only pay tax as you withdraw money from the pot.
For example, if you save £500,000 over your lifetime into a pension, and it pays out £25,000 per year, then you will pay tax on the £25,000 each year as you receive it as income.
As a further example, if you contribute £40,000 into your pension and the investments within it grow by 8% to £43,200 you will not owe tax on the gain as the pension can grow tax free.
25% tax free lump sum
As a further benefit to saving for retirement, you are allowed to withdraw 25% of your pension as a tax-free lump sum on your date of retirement (usually 55 years old at the earliest).
This means that if you invest £40,000 into your SIPP while you are 54 years old, you can retire in the next year and withdraw £10,000 tax free straight away. The remaining £30,000 will then be taxed whenever it is withdrawn from the pension.
The drawbacks of investing into your pension
Although there are great tax benefits, the biggest drawback of investing money into your pension is that it is held there until you retire.
There are some scenarios where it can be withdrawn, however, these are usually only if you are seriously ill or facing a life threatening illness.
Therefore, if you want to draw money out of your business so that you can spend it, investing into a pension (or a SIPP) is not the best approach unless you are nearing retirement.
If you have any other questions on pensions and how they work then please feel free to get in touch with us.