Dividends. Well, technically dividends with a tax-efficient salary thrown in.
The reason for this is because of the tax rates that apply to the two types of income and the fact that you also have national insurance contributions to pay on a salary. These can be via class 1 contributions on an employers payroll or class 2 and 4 contributions via a self-assessment tax return.
What is salary and how is it taxed?
Salary is the income you receive when you work for a third-party employer or yourself via your own limited company via PAYE. Alternatively, you can receive wages. The difference between the two is that you receive a yearly salary split over 12 months whereas wages get paid by the hour/day.
As an example, let’s consider that you are on a gross salary/wage of £50,000 after expenses for the year.
PAYE Tax Bands
|Band||Taxable income||Tax rate|
|Personal Allowance||Up to £12,500||0%|
|Basic rate||£12,501 to £50,000||20%|
|Higher rate||£50,001 to £150,000||40%|
|Additional rate||over £150,000||45%|
National Insurance Contribution Bands
|Category letter||£118 to £166 a week (£512 to £719 a month)||£166.01 to £962 a week (£719.01 to £4,167 a month)||Over £962 a week (£4,167 a month)|
For the sake of PAYE tax, the first thing we need to do is work out your taxable pay so we’ll take your £50,000 and we’ll deduct your tax allowance of £12500 (standard allowance for this year, HMRC will send you a letter stating if yours is different). This leaves you with £37500 of taxable pay. This will get charged on the lower tax rate at 20% meaning the tax you pay on the £50,000 is £7500.
But wait, there’s more. You’ve next got to work out the national insurance, specifically Class 1 contributions also known as employee contributions. So we’ll take your gross amount of £50,000 again and we’ll deduct the threshold before you start incurring national insurance contributions of £8632. This means that we have £41368 of income to work out NIC’s on at 12% The amount you need to pay for NIC’s will therefore be £4964.16
This means that out of the original £50,000, you’ve only received £37535.84.
What are dividends and how are they taxed?
This is the income you receive from a company’s profits based on your percentage of shares in that company. For a small business that you created, you will likely be the only shareholder and therefore will be entitled to all of the dividends paid out.
So let’s consider that your company has profits of £50000 after expenses but before corporation tax (not including salary from your own company, this will be worked out below).
|Tax band||Tax rate on dividends over the allowance|
From this £50000, you will take a tax-efficient salary of £8632 (so no PAYE tax or NIC’s) and you will not get taxed on this as it is covered by your £12500 tax allowance for the year.
This will also mean that the corporation tax on the remaining £41368 at 19% is £7859.92.
If we deduct this, we are left with £33508.08 to take as dividends. The breakdown for tax on this is;
£3868 tax-free utilising the rest of your tax allowance
£2000 tax-free utilising your dividend allowance
£27640.08 at 7.5% = £2073.01
This means of the £50000, you get to take home £40067.07 which is £2531.23 better than the salary equivalent of £37535.84.
Let’s see those graphs again together so we can compare.
As you can see, the dividend tax remains lower than the PAYE tax all the way. Throw in the Employee NIC’s and it increases the difference even further.
Now that we have determined that dividends are the better option. The first step is to make sure that you are working through a limited company. If you are not sure of this or you wish to set one up, feel free to contact us and we get you up and running in no time.
Assuming that we have done this already, and you have been using your company for about a month, we can work together with you to get all of your figures in order and work out the tax-efficient dividends you can take out of the company for personal use.
Things to keep in mind
The first is that the only limit on salary from a third party is how much you can get them to pay you. Dividends, on the other hand, are limited to the amount of retained earnings that you have in the company so no profits after corporation tax means no dividends for you to take. Taking more dividends out of a company than there are retained earnings in the company is an illegal practice so keep this in mind before you go emptying the bank.
IR35 is another concern. Simply put, IR35 means that if you look like an employee of your client, you will get taxed like an employee of your client. This negates any benefit you receive by working through a limited company. You pay extra tax as an employee would while also incurring the costs of running a limited company. You end up worse off than if you just worked for your client as an actual employee in the first place. If you are considering working through a limited company and are unsure if your contracts with clients may fall under IR35, please call us to discuss this.
Tax brackets. In the example given above we discussed income up to £50,000 if you go above this amount however, the tax rates increase. For salaries, this goes from 20% to 40% and for dividends, this goes from 7.5% to 32.5%. The increase is bigger for dividends but you are still better off. This is only concerning the income over the £50,000 threshold, everything below that is still calculated the same.
As mentioned before, dividends are based on the shares you have in the company and the types of shares can vary. These can vary from ordinary shares to special rights shares and even ABC shares so if you would like to discuss your options and what is suitable for your situation, give us a call and we can go through all of this with you.
Finally, we come to entrepreneurs relief. If you have a lot of profits in your company that you wish to take out and no longer want to run your company. We can close it for you so that you can take advantage of entrepreneurs relief. This will provide you with the ability to take money out of your business at a tax rate even lower than you would have received via dividends tax. Let us know if this is a service you require.
Still unsure, speak to one of our accountatns in London. Call on 0208 577 0200