Question:

“I am an IT contractor operating through a limited company and I use the low salary / dividend combination for directors and make sure I stay below the higher tax band so that I don’t have personal tax to pay on my dividends. Can you advise what the best mix of salary and dividends is for the 2015/16 tax year i.e. from April 2015?”

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UPDATE 1 : If you want to read about the changes to how dividends will work from April 2016 please see our article HERE

UPDATE 2 : we have now published an article about the optimum salary and dividend levels for the 16/17 tax year HERE

Answer:

Paying yourself a low salary and then taking out any further money from your company as dividends is a very common strategy amongst contractors, freelancers and owner managed small businesses.

Getting this mix correct is essential to ensure that the most tax efficient extractions are made so here goes….

Many people choose to take a low salary and then dividends up to the higher tax band (£42,385 for the 15-16 tax year) because as long as your total personal income including dividends is below the higher tax band then there is no personal tax to pay. We will explain the options for this strategy for the 2015/16 tax year (6th April 2015 to 5th April 2016).

In the 2014-15 tax year the government introduced something called the “Employment Allowance”. This is an initiative that allowed most companies to be exempt from paying the first £2,000 of Employers National Insurance (but not Employees National Insurance). This scheme has now been extended to the 2015-16 tax year.

Given the extension of this allowance there continues to be two salary levels in 2015-16 that can be extracted dependent upon the level of administrative burden the director/shareholder is willing to tolerate.

The personal allowance has increased for the 2015-16 tax year from £10,000 to £10,600. This means that the Optimum salary level for the tax year (starting 6th April 15) is higher, but brings with it similar issues to the previous tax year. We have outlined below two suggested options for your payroll for 2015-16.

For these options we have assumed a basic situation where there is only one director / shareholder of the company and there are no other earnings outside of the company. We have also assumed that you are entitled to the standard tax free allowance for the year (i.e. that you are on a standard tax code of 1060L)

Before outlining the two options we have also provided a take home pay calculator for limited company contractors and freelancers which you might want to check out so you can see how much your corporation tax and income tax will be and how much you will earn as a combination of salary and dividends.

Option 1  – most tax efficient but a little more admin

Take an annual gross salary of £10,600.

This is the standard tax free allowance for 15-16. Yours could be a bit lower if HMRC adjust your tax code for any reason. If that is the case then your salary should be reduced to your own personal allowance level, but for simplicity we will assume £10,600.

Although this level of salary will not attract any income tax charges, there will be some Employees NI to pay which will total £305. No Employers NI needs to be paid due to the Employment Allowance.

The overall tax and NI savings of using this strategy vs Option 2 is £203 (this is the additional corporation tax saving less the employees NI that has to be paid).

On the admin side, you will need to pay some National Insurance to HMRC – if JF Financial manages your payroll we will tell you what needs paying and when. If you forget there are potentially interest charges and fines which could outweigh the tax savings made.

There is another slight drawback with this level of salary in that it allows a slightly lower combination of cash and dividends to be extracted before you hit the higher tax threshold. So for clients who like to take their salary and dividends right up to the higher tax threshold but then leave anything above this in their company, using a £10,600 salary would mean £51 less salary and dividends can be taken out. This makes the net benefit of this method £203 tax savings less £51 lower dividends = £152. This is explained in the table at the end of this article.

Option 2 – slightly less tax efficient, but a bit simpler

Take an annual salary of £8,060 which is £670 per month (rounded)

You will miss out on £203 of tax savings (although this is reduced by £51 if you take salary and dividends up to the higher tax band as discussed earlier), but it’s simpler to administer and as it is below the employees national insurance threshold there are no national insurance payments to make to HMRC.

Even though you are not paying any NI, because it’s above the “Lower Earnings Limit” for NI , you are still protecting your entitlement to future state pension and benefits at this level of salary. If you like to keep things simple then we recommend this level.

Both of these options assume that you are not caught by IR35.

Maximum Salary and Dividend Combination to Higher Tax Threshold 15-16

The below table shows how to maximise your salary and dividends for both options by ensuring you don’t go into the higher tax threshold and trigger personal tax charges. This assumes you have no other earnings outside of your Company Salary and Dividends. Also bear in mind if you have a student loan you will still have repayments to make on that with these strategies through your personal tax return.

In addition please do remember that your company needs to have sufficient distributable profits to cover these dividends.

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