One of the main benefits of contracting is the financial freedom it can give you. You decide what contracts you wish to take, you negotiate your fees, and have much more control over your take-home pay. The difference with not being paid via PAYE means you will be responsible for declaring your earnings and paying the necessary tax and National Insurance Contributions each year.
It’s really important to be clued up on the tax bands and earning thresholds so that you don’t get an unexpected and hefty tax bill at the end of the year. There are a few different options that Limited Company contractors can use when it comes to paying yourself in a tax-efficient way, most commonly by combining salary and dividends.
Every contractor is different, so we recommend speaking to a specialist limited company contractor accountant, like ourselves at Intouch Accounting, for th best advice on how best to distribute your earnings. But for now, here’s a brief breakdown of salary, dividends, and how to utilise them in the most tax-efficient way.
Salary
You can take a salary from your Limited Company to pay yourself just as you would be paid in permanent employment, and the best part is, salaries are an allowable expense to your business, so you get tax relief on this and it will ultimately lower your Corporation Tax bill.
How much should I pay myself?
The salary you choose is ultimately down to you, but there are some things to consider before you decide how much to pay yourself. The personal tax free allowance for 2019/20 is £12,500. However, you will be subject to NIC deductions on anything over £8,632.
If it’s just you in your business, and you don’t have a contract of employment, the National Minimum Wage Regulations don’t apply, so if you wanted to you could choose to pay yourself £8,632 per year, which won’t be subject to any NIC deductions. With the Lower Earnings Limit at £6,136, if you pay yourself somewhere between this and the NIC threshold, you can also retain your eligibility for state pension contributions too.
Limitations to a lower salary
Sure, reducing your NIC is beneficial, but there are some limitations to consider too. In paying yourself at the NIC threshold you are missing out on a chunk of your personal tax free allowance, plus many other benefits that come with a higher salary.
For example, certain insurance policies such as medical and personal accident cover are often calculated in relation to your earnings, so the less you earn, the less comprehensive cover you might be eligible for.
Further to that, to qualify for maternity benefits you must be “employed” and paid within National Minimum Wage Regulations, so in this instance a lower salary would not necessarily be more beneficial.
However, there can be benefits to a lower salary when you’re topping this up with dividends.
Combining salary with dividends
Many Limited Company contractors opt to pay themselves a combination of salary and dividends as this is often the most tax efficient way to do so. In this instance, paying yourself a low salary up to the NIC threshold (£8,632), and taking the rest in dividends means you’ll still be eligible for state pension but won’t have any National Insurance deducted from these payments.
What about tax on dividends?
Dividends of up to £2,000, plus any unused personal allowances are tax free. After that, anything up to the basic rate tax band (£50,000) is taxed at 7.5% and any dividends larger than this will be taxed at 32.5%. Dividends over £150,000 are taxed at 38.1%.
So yes, you will be subject to tax deductions for any dividends paid over £2000, but if you keep this below £50,000, then you won’t have to pay the higher tax rate. And remember, as a Limited Company contractor you’ll also be able to save Corporation Tax on your salary too.
While there are a few other ways in which you can combine salary and dividends, this example is one that works particularly well for Limited Company contractors who are the sole employee of their business.
For more information on how to calculate take-home pay, you can read our full guide to combining salary and dividends, or you can sign up for our contractor accountancy services and a dedicated Personal Accountant will be able to give you tailored accounting advice on the most tax-efficient way to pay yourself.
This blog has been prepared by Intouch Accounting. While we have made every attempt to ensure that the information contained in this blog has been obtained from reliable sources, Intouch is not responsible for any errors or omissions, or for the results obtained from the use of this information. This blog should not be used as a substitute for consultation with professional accounting advisers. If you have any specific queries, please contact Intouch Accounting.
