Taking a low basic salary with the rest of income as dividends is a common tax planning strategy for many limited company contractors, freelancers and small business owners. Here, we summarise what the limits are for employees paying basic rate tax and the best options for making the most of your hard-earned money.
2018/19 salary and dividends basic rate tax levels
Your first £11,850 of income is tax free, and any additional salary is taxed at 20%. With dividends, the first £2,000 is tax free, then for basic rate tax levels it would be taxed as follows:
- If you have any unused personal allowance (£11,850) then that element is tax free
- Any dividends in the basic tax band (up to £46,350) are taxed at 7.5%
So, if your only income was from dividends, you could receive £13,850 tax free in 2018/19 from both your £11,850 personal allowance and the £2,000 dividend allowance.
Way to maximise salary and dividend withdrawals in 2018/19
HMRC announced that from 2016/17 the NI Employment Allowance will not be available to companies where the only person on the payroll is a director, i.e. ‘single director employee’ limited companies. So, to give you an idea, below are two different basic salary and dividend options.
A: Taking a salary of £11,850 claiming the NI Employment Allowance
An annual gross salary of £11,850 will not be charged personal income tax, but it will attract some employee’s NI of around £411. However, no employer’s NI will need to be paid as it will be covered by the Employment Allowance.
With regards to dividends, there is £34,500 of dividends to take in the year, with the first £2,000 tax free, after that it is charged at 7.5% tax.
B: Taking a salary of £8,424 and a bigger dividend
The two NI thresholds relevant here are the Lower Earnings Limit (so long as you earn above this, you will protect your entitlement to future state pension and benefits, without necessarily paying any NI), and the Primary Threshold (if you earn above this, you must start paying NI).
The Primary Threshold for 2018/19 is £162 per week or £8,424 for the year. On this basis, it makes sense to draw a monthly gross salary of £702 which stays just below this threshold and you pay no NI.
So, which option is best?
Assuming you wish to take dividends up to the higher tax band but no higher, then you can take slightly more dividends with option B than with option A. This is because you are only taking just over £8.4k of salary which leaves approximately £3.4k of dividends in the tax-free allowance, as well as the £2,000 tax-free dividend allowance. This means you take more dividends than option A but pay the same dividend tax.
The net cash in pocket after income tax and employee’s NI is slightly higher in option B than option A, by £411; however, this doesn’t consider the additional corporation tax you save on the higher gross salary in option A.
For limited company contractors and freelancers, we recommend option B (due to the single director rule for NI Employment Allowance). It also has the added benefit of providing slightly more take-home pay despite costing a little more corporation tax. And there’s less paperwork as no national insurance needs paying over to HMRC.
The team at DS Accountancy would be happy to discuss your tax planning strategy. Please contact us at firstname.lastname@example.org and we will be in touch.