If you're reading this, chances are you're a business owner, who would like to save tax and grow your wealth. Well, if so, you're in luck.
First, the bad news. For many business owners, January brings the self-assessment tax deadline and the challenge of paying a big tax bill. It's often painful, and leaves you wondering if you're missing a trick and could be more tax-efficient.
Two Birds, One Stone
Tax is a big issue for business owners, so you need to know how you can leverage tax-efficient investments, such as Pension and ISAs, to reduce your tax burden, keep more of your money for yourself, and enable it to grow for your long-term benefit.
By being tax-efficient with your income, you'll save tax and benefit from compounding, which takes the strain of saving for your future self. You could say, it's like the old 'two birds, one stone'
If It's Good Enough For Einstein...
Investments in pensions and ISAs are not only tax-efficient, but also benefit from compounding interest (or in this case compounding investment returns), which could be life-changing if given the time.
A quote often attributed to Albert Einstein (although nobody knows if he actually said it or not): "Compound interest is the 8th wonder of the world, those who learn it, earn it. Those who don't, pay it."
Risk of Not Doing It
One day you'll no longer run your business and will instead ride off into the sunset in your convertible, never to return.
You may be hoping for a big capital event, such as a sale, to fund for your retirement, and there's nothing wrong with that. As long as it works out.
Without spreading some of your wealth elsewhere, that's a lot of eggs in one basket, which can go wrong and I've seen happen before.
Instead, why not be more tax-efficient now, benefit from the powerful forces of long-term compounding later, and all the while, diversify your wealth, reducing the reliance on your business to be the motor of your long-term financial security.
This holistic approach to wealth management helps secure your financial future. Here’s how:
1. Understand Your Tax Obligations
First, don't forget that you've got to pay this year's tax!
January’s tax return typically includes:
Being clear on what you need to pay, and why, will help you plan better and identify opportunities to reduce liabilities.
Speak to your accountant to better understand how you can reduce your tax liabilities for the year coming up. For example, understanding what are 'allowable expenses' which are things that can legitimately be put through the business, which reduces your corporation tax liability.
2. Pension Contributions: Securing Long-Term Wealth
Why Contribute to a Pension?
Pension contributions are one of the most effective ways to reduce your taxable income while building a safety net outside your business.
They are an allowable expense, meaning for every £1 you put into a pension as an employer contribution is £1 that is taken off your pre-tax profit figure and therefore saves on corporation tax.
Put £1,000 a month into a pension for 20 years, with an assumed investment growth rate of 6% a year.
You'd contribute £240,000 over the 20 years and end up with a pension pot worth £462,041. That's 93% more than you've put in, by saving little and often and letting the investments compound. Most of that growth comes in the later years, as the chart below shows.
Of course a 6% return isn't guaranteed, but it's not an outrageous assumption for a long-term investment return of a pension pot for most people. By taking more risk, you could achieve a higher return and by taking less risk you could get a lower return.
Anyway, by making this level of contributions, you'll also reduce the amount liable to Corporation tax by £12,000 a year, saving yourself £3,000 corporation tax each year, assuming a 25% corporation tax rate. Over 20 years, that's a cool £60,000 corporation tax saved.
If you were to instead take the money out as dividends, you'd be left with £9,000 in the business after paying £3,000 corporation tax and then be able to take £5,963 as dividends, assuming you pay higher rate tax on dividends at 33.75%.
£12,000 in your pension or £5,963 in your pocket?
Compounding Marshmallows & Choice
This is simply a real-life version of the 1970 Stanford Marshmallow experiment (Wikipedia Link), whereby children were given the choice of having one marshmallow now, or the promise of two if they waited longer.
But, if you think about it, you're given two instead of one here (£12,000 being twice as much as £6,000), except that the 'two' could multiply into many more marshmallows (money) in retirement!
Plus, if you instead take that £5,693 now, will you save it and do something useful with it, or will you likely spend it?
Play around with a compound interest calculator like this one, to see how compounding could benefit your pension contributions:
Don't forget as well, that the majority of people remain in Drawdown pensions in retirement, meaning the funds remain invested and still benefit from compounding growth, and not just up to the point of retirement.
Maximise Your Annual Allowance
Here's a little-known rule which you can benefit from as a business owner.
The standard Annual Allowance is £60,000 total contribution to pensions per person per year, and contributions cannot exceed 100% of your total pensionable earnings for the year. This means if your income is £50,000 this year, you cannot put more than £50,000 into your pension, including tax relief.
However, there is no limit on what a business can contribute to an employee's pension as an employer contribution, which therefore removes the link with pensionable earnings. Don't forget, if you're a Ltd co. business owner, you are technically an employee too.
Ensuring a business owner can retire and that the business can continue thereafter, should meet the definition of wholly and exclusively in most cases!
Exceeding the Annual Allowance
Whilst you can break the link with pensionable earnings, you can't break the link with the Annual Allowance.
However, you can carry forward up to three years of previous Annual Allowances if any of those allowances are unused, as long as you were a member of a pension scheme in those years.
The Annual Allowance gets complicated if your income is over £200,000 in a year. Then you may end up with a Tapered Annual Allowance, which starts to bring down your Annual Allowance relative to how much over £200,000 your income is. If you're making pension contributions with an income over this level, you really should think about getting financial advice.
Making Large Contributions Near to Retirement
Combining the Carry Forward rules with being able to make large employer pension contributions could be a great way to catch-up on filling your pension if you've left it late before you intend to retire.
Don't forget, when you draw on it, 25% of the pension pot is tax-free, and you can then flexibly draw the remainder as required in retirement to fit in with your tax position and ensure any withdrawals are tax-efficient.
3. ISAs: Tax-Free Growth Beyond Your Business
The Role of ISAs in Diversification
Individual Savings Accounts (ISAs) provide a tax-free environment for investments, making them an ideal vehicle for diversifying wealth.
Contributions? Tax-free ✅
Withdrawals and Dividends? Tax-free ✅
Maximise Your ISA Allowance
For the 2024/25 tax year, individuals can invest up to £20,000 into ISAs. For couples, this allowance doubles to £40,000 (although accounts can only be held in individual names), providing an excellent opportunity for family wealth growth.
Do this every year for 10 years and you've got £400,000 in ISAs. When you add compound interest principles in exactly the same way as with pensions, you can see the potential for large amounts of capital that will always be tax-free.
By withdrawing profits strategically through salary or dividends, you can fund ISA investments. Yes you'll pay tax now to do it, but having a growing pot that you can draw from tax-free provides very useful capital for you to use personally, and a potential funding source to put back in the business as a director's loan if circumstances required.
Access Before Retirement
Whilst pensions are more immediately tax-efficient, as you get tax relief on contributions, you can't access the money immediately should you need to, unless you're over 55.
With ISAs, you won't get immediate tax relief, but what you get instead is no restrictions on when you can access the money held in them.
If you're a younger business owner, it may be that taking the hit on tax efficiency immediately is worth it to ensure you've got more flexibility with your investments and the money isn't locked up until your mid to late 50's.
Where the Magic Happens - Tax-Efficient ISA & Pension Income in Retirement
This is where things can get really interesting, from a nerdy tax-efficiency point of view that is.
ISAs can work brilliantly in tandem with pensions in retirement due to our income tax system.
Each individual has a £12,570 Personal Allowance in the 2024/25 tax year. This means you can have income up to this amount and pay no tax on it.
Thereafter, income is taxed at 20% up to £50,270.
Let's say you're married and you've worked out you need £50,000 income each year in retirement to enjoy a well-earned comfortable lifestyle.
If you've properly funded your Pensions and ISAs during your working life for you and your spouse, you've got pots that allow you to be fully tax-efficient with your income, like so:
£12,570 - 'taxable'pension income, using up Personal Allowance
£4,190 tax-free pension income
£8,240 ISA income
£12,570 - 'taxable'pension income, using up Personal Allowance
£4,190 tax-free pension income
£8,240 ISA income
How do you each end up with two lots of pension income?
Well, remember that 25% of your pension is tax-free. That doesn't mean you have to take that as a lump sum. You can take a little bit of your total allowance with each income payment.
In the above example, each person withdraws £16,760 from their pension. 25% of £16,760 is £4,190. The taxable 75% part provides the £12,570, but this is within your Personal Allowance, so is free of tax.
Fund your pensions and ISAs properly, and you can take over £4,000 a month between you, without paying a penny of tax.
There are actually three neat functions of this approach:
1) Using two individual's income tax allowances instead of one.
2) Using tax-free cash for income - most people don't realise you can do this.
3) Using regular ISA withdrawals for more tax-free income. Again, most people don't know you can set up regular withdrawals from ISA portfolios.
If instead one person tried to use a pension pot without using the tax-free cash income feature, they'd need to draw £62,400 out of their pension.
That person would pay £12,400 in income tax, and if you do that for 20 years, that's £248,000 to the taxman, and £248,000 less in your retirement savings.
All tax calculation are based on 2024/25 UK tax rates.
4. Why Diversification Matters
Take Control and Reduce Your Dependency on the Business Valuation
While your business may be a valuable asset, relying solely on its valuation for your financial security can be risky. It provides your financial security now by paying you an income, is it asking too much to depend on it to provide your future income too?
Economic downturns, industry changes, or unexpected events out of your control could impact its value and the ability to sell it when you want to.
Pensions and ISAs invested in other companies around the world spreads your risk and provides an invaluable financial and psychological safety net.
Government Policy Risk
It probably hasn't escaped your attention that Business Asset Disposal Relief (BADR) has become less generous over the years.
It used to be called Entrepreneur's Relief, and at one point gave a lifetime £10m allowance of business disposals/sales, with a reduced tax rate of 10% on proceeds instead of the headline Capital Gains Tax Rate. This has reduced over time to £1m.
Capital Gains Tax rates have recently gone up, so who knows if BADR will continue in its current form?
By moving money from your business to Pensions and ISAs, you take back control of policy risk of the government of the day.
Yes, Pensions and ISA policy can also be changed, but by having money split between three pots (Business, Pension and ISA) you give yourself a much better chance of being able to absorb any changes and be flexible with where you draw capital from, as opposed to having all your eggs in one basket, subject to the whims of the Chancellor of the day!
5. Align Strategies with Business and Personal Goals
Salary, Dividends, and Contributions
Plan your income from the business to strike the right balance between salary and dividends. Use salary to make pension contributions and dividends to fund ISA investments, ensuring tax efficiency and wealth diversification.
Leverage Surplus Business Cash
If your business generates surplus cash, consider channeling it into tax-efficient investment vehicles. This approach reduces taxable profits while strengthening your personal financial position.
6. Plan Ahead for a Holistic Wealth Strategy
a) Set Up a Tax Reserve Fund, Pay Yourself & Save for Your Future
Allocate a portion of your income regularly into a reserve fund for future tax payments, while ensuring other funds are directed toward diversified investments. Ask your accountant to help you estimate how much you should be holding back, work out how much you need to draw from the business to sustain your lifestyle, then invest for your future.
b) Work With a Financial Planner
A financial planner, ideally a highly qualified and independent one, who already works with clients like you, can help align your personal and business financial goals, ensuring that you maximise your opportunities for diversification and tax efficiency.
A good financial planner will also help you understand when might be the right time to move into retirement, not just from a financial perspective, but also with emotional and lifestyle factors considered.
Remember, the accumulation of money isn't all there is to it, it's using it for a life well-lived that matters.
The figures provided in this article are for example purposes only, investment growth figures are not guaranteed and returns will depend on a number of factors.
This is not a recommendation to invest in pensions or ISAs, as each individual's circumstances are different, it is designed to provide information and why pensions and ISAs may be appropriate.
Jamie is Lab Financial Planning Managing Director, and a Certified Financial Planner™. He advises business owners on an ongoing basis to help with their tax-efficient financial planning, and ensuring that they and their family are well protected, in any scenario.
If you'd like to discuss your financial planning, why not get in touch to see if we can help?
Remember, there are no stupid questions. Everyone has a different level of knowledge about money and planning their finances. We speak in plain English to help take away the fear and empower you to use your money well.
