I am an IT contractor working through a Limited Company. I invoice approx £100k per year + VAT (I am on the flat rate scheme) and have little expenses. I don’t have any other income outside of my earnings from my company (salary and dividends) and I am not caught by IR35. I have to date been keeping my dividends below the higher tax band so have been building up some profits in my company but I need to start drawing down higher dividends from my company soon – can you outline what the personal tax effect of this will be?

Dividend

The most tax efficient way to run a company is to pay a specific mix of salary and dividends to keep the directors/shareholders below the higher rate tax band. You can see our advised rates for 15/16 here.

However there are occasions where this is not possible or, as in this instance, further extractions are preferred. Once the higher rate tax threshold is breached it can lead to quite significant personal tax liabilities.

The following numerical examples are for cash dividends taken in the 2015-16 tax year and assume that a salary is already being extracted of £10,600 during the year.

dividend higher rate example of tax

As can be seen in the example; the extra £40,000 taken between £40,000 and £80,000 increases the tax liability by £10,000 giving a marginal tax rate of 25%.

Once you go above £100k of total gross income the personal allowance begins to be withdrawn and hence the following £20,000 of extraction attracts a further tax charge of £9,505 (a marginal rate of over 47%). At a cash dividend extraction of £160,000 there is a section of dividends being charged at the additional rate, and as such you can see that the tax charge increases accordingly.

From a tax planning perspective, if £160,000 was required to be extracted from the company over a period there is some logic in delaying the second half of this withdrawal from the company until the start of the following tax year. This would avoid the withdrawal of the personal allowance and also the addition rate tax.

A further tax planning point to consider is transferring shares to a spouse where it is possible and tax-efficient to do so.

It is also worth bearing in mind the changes to the way dividends work from April 2016 which may make it attractive to accelerate some of your dividends before the end of the 15-16 tax year.