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How much should I take out as salary vs. dividends?

10th August 2016

Article written by:

iContract

There are tax benefits to contracting, as well as regulations such as IR35 to be aware of

In this post, iContract co-founder Amanda Cai explains how contractors can strike the balance between paying salary and dividends. 

Historically, this has been an easy answer. Take the minimum salary level under the income tax personal allowance, and take the rest in dividends. This is because dividends were taxed at a lower rate than income tax, so you could effectively reduce your tax bill by allocating as much of the income to dividends as possible. 

However, the recent change in dividend tax rules changes things, and has closed the gap between salary and dividend rates.

Here are some examples to illustrate this: 

John is on a contract with a rate of £500 per day. He worked 200 days in total from April 2016. 

Total Revenue = £500 x 200 = £100,000 

Business Expenditure = £20,000 

Net profit = £80,000 

Corporate tax rate @ 20% of £80,000 = £16,000 (although salary is tax deductive, but here we assume you save £16,000 in the account to pay future corporate tax on a conservative basis)

Remaining cash in the bank after corporate tax = £80,000 – £16,000 = £64,000  

Scenario 1: John wants to take out £50,000 in total from a combination of salary and dividends and leaves the remaining £14,000 in the business as the retained earnings. Salary is paid on a monthly basis while dividends can be taken out any time of the year.

To take out his personal allowance of £11,000 as salary only, and the rest as dividends.

Salary = £11,000 (monthly salary £917)

No income tax payable 

Dividends = £39,000

The first £32k is subject to a basic dividend rate of 7.5%. John can use his £5k dividend allowance to offset the lower threshold dividend tax. The remaining £7k is taxed at a higher dividend rate of 32.5%. Therefore the dividend tax John pays = (£32,000-£5,000) x 7.5% + £7,000 x 32.5% = £4,300.

Can John reduce his tax bill by using a different combination of salary and dividends?

Scenario 2: Now let’s assume John takes out £43,000 salary and £7,000 dividends.

Salary = £43,000 (monthly salary £3,583) 

Income Tax = (£43,000 – £11,000) x 20% = £6,400 

Dividends = £7,000

Dividend tax = (£7,000 – £5000) x 32.5% = £650 

His tax bill in this case will be made up of income tax of £6,400 and dividend tax of £650, with a total tax bill of £7,050. 

However, salary is subject to national insurance contributions, while dividends are not (we will cover the national insurance contribution in part 2). This adds on additional costs for taking out salary. 

The new rule indeed closes the gap between total tax paid using different salary and dividend combinations, and the best option for calculating a contractor’s tax is not always immediately obvious. 

In order to plan your tax efficiently, you will need to consider your earnings as a combination of salary and dividends, which tax band that will put you under, and to run through several scenarios to calculate which combination best benefits you. 

Is there any way you can plan ahead to reduce your effective tax rate, you ask? Well, yes. Adjusting the total cash you would like to take out from the business instead, can put you into a different tax bucket, and reduce your effective tax rate significantly.

The magic number is basic rate bucket of £43,000!

Scenario 3: For example, in view of the high tax rates, John might decide he needs to instead take out £43,000 to keep himself within the basic rate category. He can keep more cash in the company, which can be used for investments and business purchases in the following years.

The most efficient way to take £43,000 is to fully utilise both the £11,000 personal allowances on the income tax and the £5,000 tax-free dividend.

Salary = £11,000 (monthly salary £917)

No income tax payable. 

Dividends = £32,000

Since John’s total income is £43,000, he falls under the basic dividend rate of 7.5%. 

Dividend tax = (£32,000 – £5000) x 7.5% = £2,025. 

Therefore, in taking £43,000, the total tax John will owe will be just £2,025, an effective tax rate of just 4.7%.

By reducing the total cash he takes out of the business by £7,000, John can reduce his effective tax rate significantly. 

Although every contractor has to consider his own personal circumstances when deciding how much he would like to earn from the business, in order to reduce the personal income tax bill, it is more beneficial for a contractor to keep the total income under £43,000 per year, and to take a combination of salary and dividends to fully utilise both personal allowances and free dividend amount to minimise the total effective tax rate.

One thing to note though is salary is tax deductive while dividends are not. Therefore, by taking a smaller salary, your corporate tax will increase. The best structure is probably to take a salary more than £11,000, and the rest in dividends, keeping the total income at £43,000. The optimal level will depend on your business expenditures. If you know your ongoing business expenditures, then your accountant should be able to work out the magic combination!

We will be covering the national insurance contribution and the legitimate expenses elements in part 2, so make sure you follow us on LinkedinFacebook and Twitter

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