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
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 £702 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 2018/19 this figure is £702 per month.
Dividends
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 2018/19 the way dividends are taxed changed. The new approach is simpler but increases taxes for many people. For the first £2,000 your receive, no tax is payable. After that your dividend is taxed as follows:
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.
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 19%
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 19%. So any money available for dividend payments will already be liable to tax at 20%, which must be paid by the company.