If you run your own limited company you’ll want to consider the most tax-efficient way to extract money – should this be via salary, dividends, or a combination of both?
In this article, we go through the various options to help you plan your tax strategy.
Taxation of salaries and dividends
The personal allowance for this current tax year (18/19) is £11,850, which means you only pay tax on earnings above that amount. If you’re drawing a Director’s salary from your company, any additional salary payments over this threshold would be taxed at 20%. Once you hit the higher tax band (£46,350), any additional salary would be taxed at 40%, then similarly if you hit £150,000, you would then pay 45% on additional amounts.
With dividends there is an allowance, which means that any income from dividends during 2018/19 would be taxed as set out below.
An individual’s first £2,000 of dividends are tax free. Over and above this £2,000 the dividend income is taxed as follows:
If you have any un-used personal allowance (£11,850 for 18-19) then that element is tax free
- Any dividends in the basic tax band (up to £46,350 for 18-19) attract a tax charge of 7.5%
- Dividends above the basic tax band (£46,350 for 18-19) are charged at 32.5% and at 38.1% above £150,000.
To give an example – if your only income was dividend income, you could receive £13,850 of tax free dividend income in 2018/19 from both your £11,850 personal allowance and the £2,000 dividend allowance.
Dividend distributions will be based on the shareholdings within the company and therefore some consideration may need to be given to the share structures to ensure these methods are appropriate.
Tax efficient combination of salary and dividends
For those who are Limited company contractors, small business owners or freelancers, drawing a low basic salary with additional income being extracted as dividends is a widely used taxation strategy. The theory behind this method is:
- You draw a low tax efficient salary below the personal allowance so that it does not attract personal tax
- Ensure the salary is high enough for national insurance purposes so that it counts as a year’s ‘stamp’ for your national insurance history
- The salary amount is a tax allowable cost for your business, therefore corporation tax will be saved at 19% (corporation tax rate for 2018/19) on the gross (pre-tax) salary
- Treat any additional amounts you extract from your company as dividends, which do not attract national insurance, therefore you are not paying more you are required to
The best levels of salary and dividends for 2018/19
The NI Employment Allowance means employers do not have to pay the first £3,000 of employer’s national insurance. Typically, the employment allowance means that it is slightly more tax efficient to take a gross salary all the way to the maximum tax free allowance amount (£11,850 for 18-19), however HMRC announced that from 16/17 the Employment Allowance will not be available to companies where the only person on the payroll is a director, i.e. ‘single director employee’ Limited companies.
Due to this, outlined below are two different salary and dividend options which are put together on the basis that you wish to stay below the higher tax band (£46,350). A few assumptions have been made, e.g. you are not caught IR35 and you have a standard personal allowance.
Option 1: Salary of £11,850 claiming the NI employment allowance.
Take an annual gross salary of £11,850 which will not attract any personal income tax, but it will attract some Employees National Insurance which will total around £411 however no Employers National Insurance will need to be paid as it will be covered by the Employment Allowance, making the assumption that you can claim it – and the other contributions you have to pay for your employees, do not take you over the allowance.
With dividends, the higher tax band is £46,350 so assuming you want to stay in the basic tax band this leaves you £34,500 of dividends to take with the first £2k tax free and after that they are charged at 7.5% tax.
Any dividends taken above the higher tax band will be taxed at 32.5% and even higher if you trigger other tax tipping points such as the child benefit charge at £50k, £100k tax free allowance withdrawal and the upper tax band at £150k.
Option 2: Salary of £8,424 and higher dividend
There are two National Insurance thresholds you need to be aware of:
- Lower Earnings Limit – as long as you earn above this you are protecting your entitlement to future state pension and benefits, without necessarily paying any National Insurance
- Primary Threshold – if you earn above this you must start paying National Insurance
For the ideal scenario, you would to go up to the Primary Threshold. The National Insurance Primary Threshold for 18/19 is £162 per week or £8,424 for the year. Therefore, taking a monthly gross salary of £702 which stays just below this threshold, means you would pay zero National Insurance.
Regarding dividends, assuming as with Option 1 you wish to take dividends up to the higher tax band but no further, then you can take slightly more dividends with Option 2 than with Option 1. This is because you are only taking just over £8.4k of salary which leaves approximately £3.4k of dividends that are in the tax free allowance, as well as the £2k tax free for the dividend allowance. This in effect means you take more dividends than option 1 but pay the same dividend tax.
Which of these options is best for you?
Note that the net cash in pocket after income tax and employees NI is slightly higher in Option 2 than Option 1, by £411, however this doesn’t factor in the additional corporation tax you save on the higher Gross Salary in Option 1.
For Limited company contractors and freelancers, Option 2 is recommended (due to single Director rule for NI Employers allowance) and has the added benefit of being able to achieve more take home pay despite costing a little more corporation tax.
Option 2 also has the added benefit of being less admin intensive as no National Insurance needs paying over to HMRC.
As with any tax planning advice, full consideration has to be given to your complete affairs and this strategy may not always be the best option. Please contact us should you require any further information or advice at firstname.lastname@example.org