Pension vs Dividends: The Ultimate Wealth Extraction Strategy

April 6, 2025 • 10 min read

When directors ask "How do I take money out of my company?", the answer is usually "Salary and Dividends". But looking strictly at tax efficiency, Employer Pension Contributions blow both of them out of the water.

This guide explains the "Pension Power" strategy: using your company to build personal wealth while paying zero immediate tax.

The Core Difference

1. Dividends (Post-Tax)

Dividends are paid from profit after Corporation Tax.

Step 1: Company earns £100.
Step 2: HMRC takes £19-£25 (Corporation Tax).
Step 3: You take the remaining ~£80.
Step 4: HMRC takes Dividend Tax (8.75% - 33.75%).
Result: You keep £53 - £73.

2. Pensions (Pre-Tax)

Pension contributions are an "Allowable Business Expense" (for the most part).

Step 1: Company earns £100.
Step 2: Company pays £100 into your SIPP.
Step 3: Corporation Tax is calculated on £0 Profit.
Step 4: You pay no Income Tax (until retirement).
Result: You keep £100 in your pot.

Mathematically, pensions retain up to 40% more wealth than dividends.

The "Pension Salary Sacrifice" Strategy

A "Salary Sacrifice" arrangement isn't just for employees. As a director, you can forgo salary (down to minimum wage) in exchange for direct employer pension contributions. However, because most directors already take a low salary (£12,570), there isn't much to sacrifice! The better route is simply making Employer Contributions on top of your low salary. This is functionally similar to a pension salary sacrifice limited company arrangement for large corporates, but much simpler to administer for your own LTD.

The "Wholly and Exclusively" Rule

To be tax-deductible, the contribution must be "wholly and exclusively" for the purposes of the trade.

For directors, this is rarely challenged as remuneration packages are expected to be substantial.
However, if you employ a spouse for admin work on £12k salary and give them a £40k pension contribution, HMRC will challenge it as excessive remuneration.

Limits: The Annual Allowance

You cannot pump infinite money into a pension.

Annual Allowance: £60,000 per year (for 2025/26).
Carry Forward: You can use unused allowances from the previous 3 tax years.
- Potential Total in Year 1: Up to £180,000 (if you have sufficient allowance history).

Crucial Logic for Directors: Unlike personal contributions (which are limited to your relevant earnings/salary), employer contributions are not limited by your salary.

You can take a £12,570 salary and have a £60,000 employer pension contribution. This is perfectly legal.

Case Study: The £100k Problem

Mike runs a consultancy making £140,000 profit. He needs to extract cash.

Scenario A: Maximum Dividends

He takes £12,570 Salary.
He takes £100,000 Dividends.
Issues:
1. He breaches the £100k Personal Allowance taper (60% effective tax rate).
2. He pays Corporation Tax on the full profit (£140k).
3. He pays Higher Rate dividend tax.

Scenario B: The Pension Pivot

He takes £12,570 Salary.
He takes £50,000 Dividends (staying in Basic/low Higher rate).
He puts £60,000 into his Pension.

The Benefits:

Corporation Tax: He saves £60,000 * 26.5% (Marginal Rate) = £15,900 in tax saved immediately.
Personal Tax: His "Adjusted Net Income" drops. He keeps his full Personal Allowance.
Wealth: He has £60,000 growing tax-free (compound interest) in a global index tracker.

The Inheritance Tax (IHT) Bonus

One often overlooked benefit: Pensions usually fall outside your estate for Inheritance Tax.

If you leave cash in your company = Taxed on death (or extraction).
If you take dividends and put cash in bank = Taxed at 40% IHT (above nil rate band).
If you put it in a Pension = 0% IHT. Can be passed to beneficiaries tax-free (if you die before 75).

Summary Strategy

Prioritize Pension: Fill your £60,000 Annual Allowance before taking higher-rate dividends.
Avoid the 60% Trap: Use pension contributions to keep your net income below £100,000.
Carry Forward: If you have a bumper year, look back 3 years to utilize unused allowances.

Disclaimer: Pensions lock money away until age 57 (from 2028). Only contribute what you won't need for liquidity.