Editors note: originally published 6 April 2012 and republished each year since as changes in tax law were announced.
A common and sensible question that small business owners trading through a limited company often ask is ‘how do I pay myself in the most tax efficient way’?
The answer to this question is refreshingly simple: use a mixture of salary and dividends.
Salary is the term used to describe money paid to you as an employee of the company. Money paid in this way must be taxed at source (i.e. by the company before it is passed to the employee). This scheme is called PAYE (Pay As You Earn) and ensures that companies deduct both income tax and national insurance from employees salaries and pay it directly to the tax man.
Pay £671 per month as salary
Optimising salary is mainly about National Insurance thresholds. You need to pay enough salary to avoid gaps in your record but not so much that you start to incur National Insurance payments. In most cases you should pay yourself a small salary that falls just below the limit at which national insurance becomes payable. For the tax year 2016/17 this figure is £671 per month.
Dividends are a distribution of profits by a company to its shareholders. As this definition suggests, dividends should only be paid if there is sufficient profit in the company to cover the payment.
Individuals can pay a lower rate of tax on most dividends received from the company
In 2016/17 the way dividends are taxed changed. The new approach is simpler but increases taxes for many people. For the first £5,000 your receive, no tax is payable. After that your dividend is taxed as follows:
- 7.5% on dividend income within the basic rate band
- 32.5% on dividend income within the higher rate band
- 38.1% on dividend income within the additional rate band
If you are using dividends as an alternative to salary then you’ll see quite clearly that the tax savings are significant while you remain within the basic rate.
Don’t worry about tax credits
Tax credits on dividends were part of the pre-2016 tax regime. They are difficult to understand but the good news is that you can now totally forget about them!
You don’t need to worry about the difference between net and gross dividends. The only figure you need think about is the actual cash dividend distributed by the company. This is the figure that should be listed on your Dividend Voucher and the figure you report in your annual tax return.
Remember that profits are taxed at 20%
The reason that dividends are taxed so much lower than salary is because dividends are paid out of profits rather than being a deductible expense like salary. So don’t be fooled by the headline tax rates. The profits of a company are taxed through the Corporation Tax system. For small companies this is at a rate of 20%. So any money available for dividend payments will already be liable to tax at 20%, which must be paid by the company.
Example of tax efficient payment
- A total of £46,904 from the company is paid out as follows:
- Salary of 12 x £671 = £8,052
- Company profits of £38,948, subject to tax at 20%, leaves dividends to pay to you of £30,158
- No income tax is payable on the first £5,000 and 7.5% on the remaining £25,158 which totals £1,887
- So total income after tax = £36,323 (total taxable income = £41,561, just below the higher rate threshold).
On this basis the effective tax rate is 22.5% which compares favourably to the 27% you would pay if you put all this cash through as salary (or 38% if you include the employer’s NI contributions). Note that the benefit deceases as your dividend payment exceeds the amounts above because you start to pay the additional 32.5% tax on dividends.
If you use a good piece of accounting software (check out our ClearBooks review here) then this should create Dividend vouchers for you. Technically you should also approve the payment of dividends at a board meeting and create an official board minute recording this. The belt and braces approach would be to staple a set of management accounts showing sufficient profit to the voucher and board minute. As to how many companies actually do this, I couldn’t possibly speculate 😉
If you want to find out more about day to day management accounting, check out my post on the basics of management accounting for small businesses.
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