Pension contributions & Social Care Levy

The Government recently announced the well publicised Health and Social Care Levy as the care funding solution for England along with the aim of raising additional funds for the NHS. The levy will initially be applied in tax year 2022/23 as a 1.25% increase in Class 1 (employer and employee) and Class 4 main and higher rates of National Insurance Contributions (NICs). From 2023/24, NIC rates will return to the standard rates and there will be a separate 1.25% charge applied to all employed and self-employed earnings. The tax on dividend payments will also increase by 1.25%, at all levels, from April 2022.

How do the increases affect pension planning?

Personal contributions and salary sacrifice

The increases have no impact on those making personal pension contributions either personally or via their employer. There are no NIC savings to be made on these and this will be the same in respect of the Health and Social Care Levy. However, as many employers and employees are already aware, there can be significant advantages where the employer operates a salary sacrifice scheme, allowing personal contributions to be converted to an employer contribution by swapping salary for pensions. The additional benefit of this is the NICs savings for both employer and employee, made by reducing salary. Employers make their own decisions of how much of the NIC saving they pass onto their employees, with some passing all and some nothing at all. However, even if none, the employee will still benefit from their NICs savings.

The benefits of salary sacrifice from 2022/23 onwards will be even greater. For employees, they will save an additional 1.25% on any of their earnings they choose to give up. Employers will save the same and may be willing to pass some or all of this onto the employee. This may lead to an increase in contributions via salary sacrifice and more employers wanting to set up salary sacrifice arrangements.

It also raises the question of whether the Government will look again at salary sacrifice arrangements. It has been curtailed for other benefits over the years, but pension contributions have so far escaped any tightening of the rules. As funds raised for the NHS and Social Care will be reduced because of this option, it could well be looked at again by the Government.

Profit extraction from owner/managed limited companies          

For those in control of how they distribute funds from their own business, the Health and Social Care Levy and the increase in dividend tax rates both make the extraction of profits via pension contributions more attractive.

This is a complex area, but generally involves the choice of distribution via salary, dividends or pension contributions. To provide a shareholding director with their immediate income needs the company accountant will often suggest paying a minimal salary, perhaps up to the secondary earnings limit, with the rest in dividends. As the rate payable on both the employer and employee NICs have increased by 1.25%, this is unlikely to change despite the increase in dividend tax rates. Therefore, advisers will usually be comparing paying further dividends with employer pension contributions at the director’s marginal rate of tax.

Any further dividend payments will be subject to both corporation tax and the higher dividend tax rates (assuming the tax free dividend allowance has already been used up) of 8.25%, 33.75% and 39.35%.

In contrast, a pension contribution can be made gross, and, providing it meets the usual “wholly” and exclusively” rules, will be treated as a business expense. There will, of course, be tax when the pension is paid, but 25% of this is normally paid free of tax and the rest subject to income tax at the recipient’s marginal rates of tax.

Take, for example, a shareholding director who has already used up their basic rate tax band and whose company will have a further £8,100 of profits available to distribute as a dividend.

This is £10,000 of taxable profit from which 19% corporation tax will have been deducted. From 2022/23, this dividend would then be subject to 33.75%, leaving £5,366.

Instead, a £10,000 employer pension contribution could be made without any corporation tax deduction. If the individual is still a higher rate tax payer when the pension income is taken the net return would be £7,000 (ignoring growth and charges for simplicity).

Of course, the individual’s annual allowance and available lifetime allowance are also important factors and need to be considered in any decision to make any employer contributions.

The pension will become even more favourable for companies from April 2023, when the corporation tax rate increases to 25%, unless they are subject to the small profits rate which will be maintained at 19%.