Money: The great dividend dilemma

The Fixers

HELEN, 31, is a computer programmer and, having worked as a permanent member of staff since leaving university, she switched to contracting about six months ago.

Her first contract, for pounds 1,200 per week, was for three months and this has just been renewed. She expects this to continue at least for another year or two.

Helen has bought a limited company "off the shelf" and the contract money goes to the company. On her accountant's advice she takes an annual salary of pounds 6,000 and the rest is paid to her as quarterly dividends. This has the advantage of saving National Insurance (NI) contributions, which are payable on salary but not dividends.

She and her boyfriend have pounds 2,400 for emergencies and holidays in a joint instant-access account. Helen also has her own account with the Nationwide and has built up pounds 8,500 since she started contracting. Some of this money, however, will be needed to pay tax bills.

Helen's main concern is about pensions. She built up a respectable pension fund with her last employer (the only one to provide a pension scheme) and has contracted out of the State Earnings Related Pension Scheme (SERPS). Now she needs to arrange her own plan and has come to us for a personal pension plan. She feels that she could easily afford pounds 400 per month.

We looked into Helen's company scheme and the personal pension she used to contract out of SERPS (called a "protected rights" plan). We also checked the terms and rates of her savings accounts.

Her company scheme was a "money purchase" plan. This means that she and her former employer had paid into a pension fund and this would grow over the years and be used to buy an income in retirement. We reviewed the charges and the performance record of the investment managers who ran the fund.

For Helen's new pension contributions we hit an immediate - and not uncommon - problem. She is only allowed to put 17.5 per cent of her salary into a personal pension - dividends must be ignored. She could therefore only pay pounds 87.50 monthly (17.5 per cent of pounds 6,000) - much less than what she wanted to contribute and needed for a good level of income.

One option would be for Helen to increase her salary to around pounds 25,000 (and reduce her dividends accordingly). However, this would mean higher NI contributions.

Alternatively Helen could consider an executive pension plan (EPP). An EPP is similar to a personal pension in many ways - you build up a pension pot with an insurance company and the charges are similar - but the contributions and benefits are different as it is considered an employer's pension scheme.

An EPP allows much higher contributions to be paid in by the employer, in Helen's case, around pounds 175 pm. If she were to increase her salary, to around pounds 14,000, then she would be permitted to contribute pounds 400 pm.

Having contracted out of SERPS, the Department of Social Security (DSS) was rebating some of Helen's NI contributions into a personal pension of her choice. Now her salary was much lower than before (as above, dividends are ignored), her rebates were significantly reduced.

We therefore needed to check whether it was still worthwhile contracting out - often this is not worthwhile on low salaries. We also checked the charges and performance of the plan. Helen's company scheme and protected rights personal pension were both good arrangements. The charges were low and the investment performance had been excellent.

We suggested that Helen increase her annual salary to around pounds 14,000 in order to be able to pay pounds 400 monthly into an EPP. This would mean she would have to pay extra NI contributions but would be able to save 40 per cent tax on her pension contributions. It also meant that her DSS rebates to her protected rights personal pension would increase from around pounds 110 to around pounds 450, making it worthwhile continuing to contract out.

We selected a "level costed" plan where the charges are taken out evenly over the term of the plan. As there are no up-front charges Helen would not be penalised if she needed to stop, reduce or transfer her plan.

We gave serious consideration to recommending two schemes rather than one. However, she already had reasonably large funds with two other companies - with her former employer's scheme and her protected rights personal pension - so we felt there was already an adequate spread.

Helen was pleased that her existing pensions and savings were doing well. However, she hadn't realised the implications of paying herself a low salary and taking the majority of her income in the form of dividends. Although tax efficient, this policy caused problems with her pension planning. With some advice, that problem has now been minimised.

Fiona Price is managing director at Fiona Price & Partners, independent financial advisers, 33 Great Queen Street, London WC2B 5AA (0171-430 0366)