Tax Methods for Salary and Dividends

Contractors can maximise their post-tax earnings by paying themselves a minimal wage and the rest in dividends.

Despite dividend tax rises in April 2016, dividends remain a tax-efficient alternative to a wage. Dividends are exempt from National Insurance Contributions, which helps (NICs).

Contractors whose spouses are shareholders can use their spouse's tax allowance. They can achieve this by dividing their basic wage and dividend income to minimise tax liability and maximise net income.

Accounting for dividends

Before we describe how dividends and taxes are calculated, we'll warn you that they're difficult and you shouldn't have to do them. Your accountant and cloud accounting software will advise you. Put 25% of profits aside for your annual self-assessment tax return.

Most contractors operate by balancing compensation and dividends. See our 10 suggestions for hiring an accountant for further help. Your accountant can help you put your company's accounts online using FreeAgent or Xero.

If you're just starting out and don't have an accountant, we recommend our partner for contractors and small businesses.

Contractor pay taxed?

If a contractor pays a wage beyond their personal tax allowance (£11,000 in 2016/17), the excess is "taxable income" and income tax rates apply. Budget personal allowance is a beginning point. Some people's tax profiles imply their tax code (which shows their tax allowance) varies. Not everyone has a 1100L tax code and £11,000 allowance. To make things easy, we'll discuss a £11,000 tax allowance.

Taxable income is taxable income. Total earnings minus personal tax allowance.

First £32,000 of taxable income is 20% taxed. From £32,000 to £150,000, taxable income is taxed at 40%. Over £150,000 in taxable income is taxed at 45% (2016/17 rates).

Contractors pay 12% of gross earnings in National Insurance Contributions (NICs) on all wages over £155 per week, up to £827 per week, after which NICs reduce to 2%. To minimise taxes, most contractors keep their compensation modest.

A contractor's limited firm must also pay 13.8% employer's NICs on wages exceeding £156 per week. The contractor's employer pays this sum. By keeping wages low, businesses' and employees' NICs are reduced. This is why a low wage and dividends are tax-efficient.

Another hidden tax exists. Once a contractor's yearly income (salaries and profits) exceeds £100,000, their personal allowance diminishes. For every $2 beyond $100,000, a contractor's personal allowance drops by £1. If someone earns £122,000 or more, they will lose their whole £11,000 personal allowance. For every £2 earned between £100,000 and £122,000, 40% is taxed, but an extra pound is taxed at 40% since the personal allowance has been cut by a pound In other words, there has been an increase in taxable income.This means a 60% marginal tax rate.

Dividend taxation

Profits are distributed to shareholders through dividends. Any profitable corporation can issue a dividend. Illegal dividends occur when a corporation is not profitable.

A limited firm determines its profit by subtracting business expenditures, such as wages, from fee income. After 20% corporation tax is taken from profits, the excess can be delivered as a dividend to the company's shareholders, usually the contractor and spouse.

Contractors get a £5,000 tax-free Dividend Allowance. Despite its name, it's not a tax allowance. "Zero rate band" reduces income tax bands. Dividend tax band levels are £0, £32,000, and £150,000.

Say a £11,000 gross wage uses up the personal allowance. Let's suppose the rest is dividends. Next, evaluate the £0 to £32,000 basic rate tax bracket (at the time of writing). These dividends are taxed at 7.5%. The first £5,000 in that bracket aren't taxed due to the £5,000 Dividend Tax Allowance, therefore only $27,000 of the $32,000 is taxed at 7.5%. Dividends in the higher rate band (£32,001 to £150,000) are taxed at 32.5%. Above £150,000, dividends are taxed at 38.1%. Dividends are NIC-free.

Salary vs. dividends

Contractors getting an £8,000 minimum wage and the rest in profits will pay less tax and NICs than those taking only a salary. Because NI contributions are low.

In the limited business example, a contractor harvesting dividends would only have to pay an additional 7.5% tax on the first £27,000 of dividend earnings within the basic rate level - taking the Dividend Allowance into account. That's £2,025 Low salary and dividends maximise net income and minimise tax payments.

Personal allowances and dividend splitting

Contractors who share limited business ownership with a spouse or civil partner might profit from that spouse's unused tax allowances through 'income splitting'

A contractor might give their spouse 50% and keep the other 50%. Dividends are distributed based on shareholdings, thus the contractor gets 50% and the spouse gets 50%.

Because the spouse's personal allowance and Dividend Allowance can be used, tax allowances are doubled. By picking the low salary and dividend option, a contractor and spouse might withdraw £10,000 in Dividend Allowances from a contractor limited business after corporation tax without paying extra tax or NICs. From here, they may borrow another £27,000 at 7.5%.