Ltd Co contractor optimum salary vs dividend split 2019/20

Posted by John Yerou

on May 21st, 2019 11:01am in Contracting Matters Blog.
Last Updated on November 25th, 2019 08:45am.

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From the 6th April 2019, tax and dividend rates are changing. The changes affect how much of their income contractors can claim as salary to remain tax efficient. Here are the optimum levels of the dividend/salary split for sole director limited company directors.

The basics: HMRC taxable income 2019/20

HMRC has outlined personal tax allowance for the forthcoming tax years in typically wordy fashion. Here’s an at-a-glance table of what those allowances mean for all workers:

Income Tax (%)
Up to £12,500 0
£12,500-£50,000 20
£50,000-£150,000 40
£150,000+ 45


 

So, for the first £12,500 you earn you pay no tax. Earnings between £12,500 and £50,000 incur 20% tax. You will pay 40% income tax on earnings above £50,000 but below £150,000. Any amount you earn above £150,000 will incur 45% tax.

Example of annual tax incurred using 2019/20 income tax rates

Imagine you earned £300/day, worked a 5-day week and worked 46 weeks per year. Your annual earnings would be £69,000. Working PAYE, you’d pay:

  • 0% on earnings up to £12,500 = £0;
  • 20% on earnings between £12,500 and £50,000 (£37,500) = £7,500;
  • 40% on earnings between £50,000 and £69,000 (£19,000) = £7,600;
    • Giving you a grand total income tax payable of £15,100.

Those rates include neither National Insurance Contributions nor Dividend Allowance. As a contractor, these latter rates are as important to you as income tax rates. They’ll help you arrive at a figure to draw as salary to optimise your income.

How best to draw salary and dividends as a contractor

To understand how best to optimise your income, you need to know the NICs rates. For 2019/20, they are:

(Taxable) Income NICs Rate
Weekly Per Annum
a. <£166 <£8,632 0%
b. £166 to £962 £8,632 to
£50,000
12%
c. >£962 >£50,000 12% (as b.),
then 2% ∞


 

Most contractors will aim to set their ‘salary’ just above the £166/week mark.

By doing so, they qualify for ‘stamp’ and will be able to draw the full state pension when they retire. The rest of their income they’ll draw as dividends.

The way you work out tax on dividend drawings will depend on what other allowances you may have used. Or not.

Unlike income tax*, dividend tax rates are the same across the UK. For 2019/20, you’ll pay:

  • 0% tax on the first £2,000 of dividend drawing;
  • 0% tax on dividends if you have any personal allowance, up to £12,500, left to use;
  • 7½% on dividend drawings in the basic tax band (£50,000 threshold);
  • 32½% on dividend drawings between the basic and upper tax bands (£50,000 to £150,000);
  • 38.1% on dividend in the top band (>£150,000).

How drawing dividends affects a contractor’s income

To make our example relatable, we’ll use the same top line of £69,000. The contractor would draw £8,632 per annum as salary. That equates to £166 per week (over 52 weeks, not only the 46 weeks worked) or £719 per month.

They’d then draw £3,868 to take them up to the value of their personal allowance (£12,500). Then their tax-free dividend allowance of £2,000, making £14,500 so far, all tax free.

On the next £35,500, they’d pay 7½%, taking them up to the £50,000 threshold. That’s a contribution of £2,625.

The contractor would leave the final £19,000 in the company. That way, it would only attract Corporation Tax at 19%, or £3,610. That £3,610 + the earlier £2,625 = £6,235.

Compare that £6,235 to the £15,100 PAYE and you can see the advantage of drawing company dividends. That’s not the end of it, though.

As a director of a limited company, you are classed as an employee. Therefore, you have to pay Employer’s NICs as well as Employee’s NICs. You also ought to pay an accountant to make sure these calculations reflect your business.

On the plus side, you can claim the ‘salary’ against Corporation Tax. (Not the dividends, though!).

Optimum salary and dividend for multiple employee companies

Optimum salary can go a different way if a company has at least one employee other than the director. That’s because the director can then claim Employee Allowance.

If you’re a sole-entity contractor, you can no longer go the Employee Allowance route.

The calculation is a little more straight forward

The contractor director claims their full £12,500 personal allowance. This will incur a little Employee’s National Insurance (approx. £464). However, Employee Allowance will negate the Employer’s NICs, assuming other employees do not use it all.

The contractor will still claim the £2,000 tax-free dividend drawings. The balance of £35,500 (up to £50,000) dividend is taxed at 7½%. Any residual income would remain in the company as retained profit.

The difference in actual cash in pocket between the two ways of claiming is not that much. If you can choose the Employee Allowance route, you may be £250 (approx.) better off per annum.

*Income tax rates for Scottish contractors

If you live in Scotland, your tax bands for 2019/20 are more staggered:

Income Tax Band Rate
<£12,500 0%
£12,500-£14,549 19%
£14,549-£24,944 20%
£24,944-£43,430 21%
£43,430-£150,000 41%
>£150,000 46%

However, if you follow the prescribed route above, they will make no difference:

  • Draw a salary that triggers National Insurance contributions (£8,632 per annum);
  • Use dividends up to your personal allowance (£12,500);
  • Use your tax-free dividend drawing allowance (£2,000);
  • Then make dividend drawings up to the £50,000 allowance;
    • (dividend rates are the same nationwide).
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Author: John Yerou

John Yerou is a pioneer of contractor mortgages and owner and founder of Freelancer Financials, Contractor Mortgages®, C&F Mortgages and Self Employed Mortgages, trading styles and brands of the award-winning Mortgage Quest Ltd.




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