Contractors and owner managed businesses who operate through a limited companies can improve their after-tax earnings by paying themselves a low wage and taking the remainder as dividends from their company income.
Despite dividend tax increases, paying a low salary to yourself is still more tax-efficient than extracting cash from a company solely through a dividend payment. But beyond this, it’s best to take the rest as dividends, which are not subject to National Insurance Contributions (NICs).
However, though the dividend allowance is commonly known, not much is known about the tax on dividends. Limited company directors especially need to be aware of this information so that they can accurately and securely plan their dividend payments.
Below is a must-know overview of dividend payments and the information surrounding tax on dividends.
What are dividend payments?
If a limited company makes a profit, it may freely distribute that money to its shareholders. This is because the overall profit the company holds is the income remaining after all business expenses and obligations have been paid, as well as any outstanding taxes (such as Corporation Tax and VAT).
A company’s retained profit might have been accumulated over time, and any extra funds not distributed as dividends are kept in the firm’s bank account.
Working as a limited company with dividends is tax-efficient since company dividends are not subject to National Insurance Contributions (NICs), whereas salaried earnings are.
Dividends are paid out based on each shareholder’s proportion of the company shares, which means if a shareholder owns half of the business’s shares, they will profit from half of each dividend payout.
How are dividends taxed?
Limited companies calculate their profits by subtracting their company costs, such as wages and other expenses like insurance and accounting fees, from fee income. The corporation tax of 19% is then subtracted from the profit total. These profits are added to any retained earnings from earlier years are are available to be paid out as a dividend to the firm’s shareholders. For a contractor, this could be to them and occasionally his or her spouse.
Contractors, and owner managers who earn a taxable income, are entitled to a £2,000 tax-free Dividend Allowance. It is referred to as an allowance but it isn’t really one in the conventional tax sense. It’s actually a “zero rate band” that eats into the income tax bands. The band thresholds (£0, £37,700, £150,000) are used for dividend taxes just as they are for other forms of income like salary or rent.
For example, suppose the personal allowance has been spent on a gross income of £12,570. And let’s assume that the remainder of the earnings comes from dividends. The individual will qualify for £2,000 tax free and beyond this suffer tax at the applicable dividend tax rate.
Dividends earned within the basic band (up to £37,700) are taxed at a rate of 7.5%. However, as mentioned, the first £2,000 of earnings falls outside the taxable range because of the £2,000 Dividend Tax Allowance – resulting in only £35,700 being taxed from the £37,700 figure. Any dividend income falling into the higher rate band of £37,700 – £150,000 would then attract the 32.5% rate, whilst dividends in excess of £150,000 fall into the highest rate of 38.1%.
The most important thing to remember despite the dividend tax rate is that dividends do not attract employer NICs, which saves money in the long run – making it the most tax efficient way of taking a money.
How much tax do limited company directors pay on dividends?
The dividend taxation system was changed on April 6, 2016. The old method of grossing up net dividends through tax credits was phased out in favour of a new approach with fixed tax rates for the 2016/17 tax year and thereafter, and that’s currently how things stand in 2021/22.
HMRC will need to be informed of just how much dividend income you have received through completing an annual self assessment tax return if your total is greater than £10,000, or otherwise advised in writing.
Currently dividend income is taxed as follows:
Tax Band | 2021/22 Income | 2020/21 Income | Tax Rate |
Basic | £0-£37,700 | £0-£37,500 | 7.5% |
Higher | £37,710 – £150,000 | £37,501 – £150,000 | 32.5% |
Additional | £150,000+ | £150,000+ | 38.1% |
How can an accountant help with dividend income?
Accountants can help with a number of different aspects of dividend tax calculation. For example, they can help with issuing a dividend voucher and advise on when to distribute dividend payments, as well as when to pay tax associated with dividend payments.
Dividend calculations can also become complex, which is why an accountant can be best placed to perform them. Your accountant will be able to assist you, and cloud-based accounting software can help to make calculations quickly that comply with HMRC regulations.
For any limited company owners, maintaining the appropriate balance between salary and dividends is critical since this is how most operate. As a result, it’s best to pick an accountant that knows how to get this balance right – and at Raw, we do.
With our years of expertise, we can help business owners to issue dividend payments, and advise on other tax efficient methods to help businesses save money on income tax rates where necessary. For more information, why not have a free, no-obligation chat with one of our chartered accountants today?
