17 Apr 2019 | 08.32 am
Guest Blog: Kevin Henry, The Pension Store
'The real clincher with a director pension is that the business pays for it entirely'
17 Apr 2019 | 08.32 am
Your company legal structure is a critical business decision that has both short-term and long-term consequences. Kevin Henry, managing director of The Pension Store, offers some guidance
The question of whether to operate as a sole trader or as a limited company is one that everyone faces when starting a business for the first time. It can be difficult to answer this because it’s very subjective and your decision needs careful consideration.
That said, there are definite pros and cons to each option, and a good accountant will be able to give you a clear steer as to the most appropriate set-up for your current situation.
However, most of the factors that people use to make their decision are based on the critical operational differences between the two and their required reporting obligations. Under these headings, there’s no doubt that there can be a significant difference between the two.
There is also one very important area that tends to get overlooked when this decision is being made — and the difference it makes to your future can be substantial.
Now, it’s easy to understand why this doesn’t get much of a look in. Retirement is usually a long-term issue, while the priorities of starting a business are usually more short-term focused, especially in the early years.
Generally speaking, the self-employed option is the easier of the two but it’s best to make any decision like this with all the relevant information, so it’s critical to understand the differences. The only way you can do this is by actually seeing the difference for yourself.
The pension entitlements between PAYE workers and company directors are based on completely different funding models.
The personal pension system for sole traders is based on a defined contribution model. This means that you can get a specified amount of tax relief on contributions up to a maximum limit based on your income and your age.
For directors, the system is more of a defined benefit system based on six variables, which populate a range of funding formulas provided by the Revenue Commissioners.
These formulas allow directors to build towards predetermined targets specific to their unique circumstances, which can be done on a straight-line basis.
Leaving aside the fact that you can fund substantially more through a director’s pension, the real clincher with a director pension is the fact that the business pays for it entirely. Director pension contributions are a legitimate business expense, whereas personal pension contributions are personally funded.
In addition to this, company directors also have the option of exercising large, one-off contributions from the business, where previous funding was either short of target or non-existent. There are rules around this but it effectively allows them to play ‘catch up’ and make up for lost years, which is something nobody else can do.
Finally, even if you’re not into pensions, a director can still instruct their business to fund up to 1.5 times their final salary as a tax-free lump sum up to €200,000. This is a nice option to have to ensure you don’t walk away empty-handed — but you need to have 20 years service to avail of it.
Your time is important and each year counts towards your entitlements as a director, which is why your initial set-up decision is so important. You can see all of your options as a director laid out for you using our calculator.
I’m self employed now, is it worthwhile changing?
Well, that depends. If, for example, you’re approaching 50 then this might be a very good time to sit down and look at your options, while you still have time on your side to do so. That’s because with some planning you could be set up and trading by age 55 which would enable you to complete the 10 years needed to maximum fund.
What else should I consider?
The key element for director pensions planning is consistency in both time and income. Your time counts, so here are some other lifestyle things to consider if you are thinking of making the switch:
1. Is this the kind of work I will be doing right up until the end of my career?
2. Will I be able to maintain a consistent level of income until then?
3. Do I have excess income being taxed at the higher rate that I don’t necessarily need to take right now?
4. Has retirement planning become a priority?
5. Is the tax-free cash option something I’d like to have?
How much time do I need as a director?
You need 20 years service to maximise the tax-free cash option. However, you only need 10 years in order for the company to be in a position to fund for the maximum allowable pension fund based on the funding limits set by revenue.
Aside from the obvious wealth-building capacity, a limited company protects the founder’s personal assets in the event that the business fails. And while most self-employed people have some degree of professional indemnity cover in place, these policies only cover your liability up to a set limit.
A limited company offers complete protection from failure and creditors, which could make a huge difference if things go bad or if there is a litigation risk to the work you do. That’s because it operates as a completely separate, and legally distinct, entity from you.
How can I find out my options?
Pensions are complicated and most people find them a bit of a challenge, so we’ve built an online adviser to make them simple for you. This way, you can see exactly how the numbers work in your exact situation, regardless of how you’re set up.
It accurately calculates your pension potential based on the aforementioned limits, your rate of tax relief, relief weighting via the tax bands and all the relevant funding formulas for company directors.
All you need to do is fill in your details and change your status from ‘self employed’ to ‘company director’ if you want to run a comparison and see the difference for yourself.
If you need advice about a pension or are looking to set one up, as a sole trader or company director, then just send a mail to email@example.com to get started.
+ Kevin Henry is Managing Director of The Pension Store