Why Pensions Remain Vital in Business Owners’ Profit Extraction Strategies
With the upcoming changes to inheritance tax from 6 April 2027, where most unused pension funds will be included in estates for tax purposes, many business owners might wonder if pensions still hold value in their profit extraction plans. This shift certainly challenges the traditional approach of leaving pensions untouched while spending other assets, but it does not negate the core advantages of using company profits to secure retirement income.
At its heart, a pension is designed to fund your retirement—not to serve as an inheritance for your children. Recognizing this purpose is crucial, especially as alternative wealth accumulation methods within companies, such as retaining profits for a low-tax sale, become less attractive due to recent tax changes.
The Decline of the “Leave It in the Company” Strategy
Historically, owner-directors often took minimal income, paying corporation tax on surplus profits and retaining these funds within the company. This cash accumulation, combined with business growth, was intended for extraction later through a share sale or liquidation. The appeal was largely due to Entrepreneurs’ Relief, which allowed qualifying gains to be taxed at a favorable 10%, compared with higher rates on dividends.
However, the landscape has shifted dramatically. Entrepreneurs’ Relief was replaced by Business Asset Disposal Relief, with its lifetime gain limit reduced from £10 million to £1 million in 2020. Moreover, its tax rate increased to 14% in April 2025 and will rise further to 18% in April 2026. Gains outside this relief may attract Capital Gains Tax (CGT) at 24%. While retaining profits can still be beneficial if the business requires capital, relying solely on favorable CGT treatment for retirement funding is now riskier.
Retirement planning should not hinge exclusively on finding a buyer, securing an optimal valuation, and benefiting from fluctuating tax reliefs at the time of sale.
Why Employer Pension Contributions Remain a Strong Option
Employer contributions to registered pension schemes offer distinct tax advantages. These contributions are generally deductible when calculating taxable trading profits, reducing the company’s corporation tax liability. Importantly, the funds go directly into the pension without first being treated as salary or dividends, thereby avoiding income tax and National Insurance charges.
Unlike personal pension contributions, employer contributions are not limited by the director’s salary, although the annual allowance rules still apply. This is especially beneficial for owner-directors who take modest salaries supplemented by dividends.
Furthermore, pension investments grow free from UK income tax and capital gains tax while within the pension wrapper. Although withdrawals are usually partially taxable, the key advantage lies in securing tax relief upfront and planning withdrawals strategically based on future income needs, rather than increasing taxable income today unnecessarily.
Managing the £100,000 Adjusted Net Income Threshold
Profit extraction strategies become more complex once adjusted net income exceeds £100,000. Beyond this point, the personal allowance reduces by £1 for every £2 above the threshold and completely phases out at £125,140. For taxpayers in England, Wales, and Northern Ireland, this effectively creates a 60% marginal tax rate band before National Insurance is considered. Scottish taxpayers face different rates, and dividend income requires separate calculations.
Opting for employer pension contributions instead of additional salary or dividends can help keep adjusted net income below this critical threshold, preserving the personal allowance and reducing overall tax liability.
Additionally, eligible personal pension contributions can further reduce adjusted net income, potentially restoring some or all of the personal allowance. It is important to note that company contributions do not simply offset personal income already received.
Accessing Pension Savings Without Retiring
Pension funds are typically accessible from age 55, rising to 57 from 6 April 2028, subject to scheme rules and exceptions. Importantly, accessing pension savings does not require retirement. This flexibility can alleviate concerns for business owners planning to work beyond these ages.
Taking a pension commencement lump sum (PCLS), usually up to 25% of the pension benefits accessed and subject to a lifetime allowance (currently £268,275), provides tax-free cash. Importantly, withdrawing only the PCLS and leaving the rest invested in drawdown does not trigger income tax on the lump sum nor the Money Purchase Annual Allowance (MPAA).
However, drawing taxable income through flexi-access drawdown does trigger the MPAA, restricting future defined contribution pension savings to £10,000 annually (including employer contributions). For business owners with sufficient ongoing income, it may be advantageous to take only tax-free cash initially, preserving the ability to contribute more to pensions later.
Prioritizing Retirement Funding and Separate Legacy Planning
The standard pension annual allowance is currently £60,000, though this can vary. Additionally, unused allowances from the previous three tax years might be carried forward to increase contribution capacity. Nevertheless, contributions must balance pension funding with maintaining adequate working capital and investment reserves.
The inheritance tax changes effective from April 2027 heighten the need for careful legacy planning. However, they should not cloud the primary question: how will you finance your life after work?
Pensions continue to be a tax-efficient vehicle for extracting profits from a company and building a retirement fund independent of the business’s value. Contributions should be made with a clear plan for retirement, while legacy planning remains a separate, equally important conversation.
Tax treatment varies by individual circumstances and is subject to change. Investment values can fluctuate. This article provides general information and should not be taken as personalized advice.
Key Takeaways
- A company contribution to a registered pension can typically be deducted from taxable trading profits, reducing corporation tax. Unlike salary or dividends, these contributions go directly into the pension without triggering income tax or National Insurance.
- Employer pension contributions are not tied to the director’s salary and do not trigger the Money Purchase Annual Allowance. The standard annual allowance is £60,000, with potential to carry forward unused allowances from the previous three tax years.
- When adjusted net income exceeds £100,000, personal allowance tapers and disappears at £125,140. Employer pension contributions can help keep income below this threshold, preserving tax benefits.
- Pension savings can usually be accessed from age 55 (rising to 57 in 2028). Taking only the pension commencement lump sum (up to 25%, tax-free, subject to a lifetime limit) does not trigger the Money Purchase Annual Allowance, allowing remaining funds to stay invested without restricting future contributions.
- Inheritance tax changes from April 2027 make legacy planning more important but do not undermine the fundamental case for pension saving. Pensions remain a tax-efficient way to extract profits and build retirement funds. Legacy planning should be addressed separately.
