For many freelancers and contractors, maximising take home pay is one of the considerations when deciding to operate through a limited company. This can be achieved by taking a lower wage and topping it up with dividends. As dividends are exempt from National Insurance contributions, they can be a more tax efficient way of getting paid.
However, dependent on your circumstances, you still have to pay some tax on dividend payments, and from April 2016 the way Dividend tax is calculated will be changing. We outline below what you need to know about the new dividends system and how it will affect the money you bring home.
How do dividends currently work?
Typically, as a company director you can keep your salary below your Income Tax Personal Allowance (thereby avoiding Income Tax payments) and take the rest of your ‘pay’ from your company’s profits.
Dividends are taken out of your profits after Corporation Tax has been deducted. At the moment, income tax is due on the gross dividend amount after a notional dividend tax credit of ten per cent is applied. The amount of dividend tax you pay is tiered (similar to regular PAYE income):
- The basic tax rate is applied on dividend payments between £0-£31,865 with a ten per cent dividend tax rate (this is effectively cancelled out by the ten per cent notional dividend tax credit)
- The higher tax rate is applied on dividend payments between £31,866-£150,000 with a 32.5 per cent dividend tax rate (this works out as 25 per cent after the ten per cent notional dividend tax credit is applied)
- The additional tax rate is applied on dividend payments in excess of £150,000 with a dividend tax rate of 37.5 per cent (this works out as 30.56 per cent after the ten per cent notional dividend tax credit is applied)
However, from April 2016 the Dividend Tax Credit will be replaced by a zero rate tax band (tax-free Dividend Allowance).
What is the new zero rate tax band (tax-free Dividend Allowance) for Dividend income?
Starting from April 2016, there will be new tax rates as well as a new tax-free ‘allowance’ of £5,000 on top of your existing £11,000 personal allowance. Unfortunately, for many limited companies this means a tax increase.
Whilst you don’t pay tax on the first £5,000 of your dividend income, you do have to pay dividend tax depending on the income tax bracket you fall into:
- 7.5% on dividend income within the basic rate band up to £32,000 (the first £5,000 of this is tax free).
- 32.5% on dividend income within the higher rate band, which falls between £32,001-£150,000
- 38.1% on dividend income within the additional rate band (over £150,000)
When calculating your dividend vs salary options, there are other factors to take into account too:
- The £5,000 ‘allowance’ sits within the basic rate band, meaning that up to a maximum of £27,000 in dividends can be taxed at the 7.5% basic rate.
- Your personal tax allowance is reduced by £1 for every £2 your total income is over £100,000.
If you draw a salary of £8,060, you can take £34,940 in dividends, which will take you up to the £43,000 higher rate tax threshold (£11,000 personal allowance plus £32,000 basic rate band). After deducting the £5,000 tax-free dividend ‘allowance’, your taxable dividends are reduced to £29,940. As you still have £2,940 remaining of your personal allowance (£11,000 – £8,060), you’ll only pay dividend tax on the remaining £27,000 (£29,940-£2,940) at 7.5%, which is £2,025.
For a detailed analysis of how your finances will be affected by this change, we recommend talking to an accountant to give you a personalised breakdown. They’ll also be able to help you balance the ratio of salary and dividends in order to maximise your earnings based on your existing set up and income you require.
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