What’s best salary or dividends?  

As is so often the case, it depends! Not a particularly helpful answer for those looking at this through a black and white view finder, but the truth is it really is very grey and depends on each contractor’s individual circumstances.

That said there are obviously some points to make that may help you decided your strategy and maximise your post-tax earnings.

Let’s start with IR35. If you find yourself inside then you will have no choice but to treat all earnings as employed earnings and pay the tax accordingly. For those contactors outside IR35 there are more options available and the question of salary v dividend is very relevant.

How are contractor salaries taxed?

Salaries are taxed according to Income Tax Rates and are taxed at source through a PAYE scheme using the contractor’s tax code. The full tax allowance for 2021/22 will be £12,570 and whilst contactors will therefore have a tax code of 1257L some will have been adjusted for previous underpayments or benefits in kind. For the purposes of these examples, we will assume a full allowance is available.

Taxable income is the amount of earnings that are subject to income tax. It is the total amount of earnings minus the personal tax allowance for the individual.

For the year 2021/22 the first £37,700 of taxable income is subject to income tax at the basic rate of 20%. After £37,701 is reached, the taxable income is subject to a higher rate of tax at 40% until £150,000. Any taxable income exceeding £150,000 is taxed at the 45% additional rate.

In addition to Income Tax, salaries attract NIC payments. As an employee of your own company you will also pay 12% of gross earnings in employees National Insurance Contributions (NICs) on all earnings over £184 per week, up to £967 per week, after which NICs drop to 2%.

Your limited company must also make additional employer’s NICs contributions of 13.8% on the portion of your earnings taken as salary which is over £183 per week.

Keeping your salary low, both employers and employees national insurance contributions (NICs) are minimised. This is key to why paying a low salary and the rest in dividends is the most tax efficient route for many.

For those contractors lucky enough to earn salaries in excess of £100,000 be aware of another “stealth tax”. Your personal allowance shrinks at this point as for every £2 you earn over £100,000 your personal allowance reduces by £1.

Despite the dividend tax hikes implemented in April 2016 and the reduction in the tax free dividend allowance from 2018, extracting cash from a company via a dividend payment still offers a more tax-efficient alternative to paying oneself a salary.

How are dividends taxed?

Dividends are a distribution of a company’s profits to its shareholders. As long as the company is in profit, it can declare a dividend at any time. Dividends declared when the company is not in profit are called illegal dividends, and issues arise.

A limited company calculates its profit by deducting its business expenses, of which salaries are one. The resulting profits are taxed to Corporation tax at 19% and any profits left can be distributed as a dividend to the company’s shareholders.

You will have a £2,000 tax-free Dividend Allowance for 2021/22, which acts like an extension to your "zero rate band".

Let’s assume you have utilised your personal allowance for the year by taking a salary of £12,570 your dividend will then be taxed as follows. The first £2,000 of dividends will be tax free, with the next tranche taxed at 7.5%. This rate will apply to all dividends paid up to the level of £37,700, but with the first £2,000 within that band are not taxed at all, due to the Dividend Tax Allowance of £2,000 - so only £35,700 of the £37,700 is actually taxed at 7.5%.

Any additional dividends paid will fall into the higher rate band (currently from £37,701 to £150,000) and will attract the 32.5% higher rate of tax. Any dividends in excess of £150,000 are subject to a rate of 38.1%.

Salary vs Dividends – a sample calculation

So what does all this mean in terms of take home pay? Let’s compare the take home for a contractor who has invoiced his client £80,000 fee income. The contractors apply the following strategies:-

• Salary only

• Salary equal to the NIC threshold, the remaining in dividends

If you extract a minimum salary equal to or below the National Insurance threshold, or even the personal allowance, and the balance in dividends you will end up paying significantly less combined tax and NICs than a contractor paying themselves just a salary.

Expenses

As well as any salary and dividend you take, you should also remember that expenses incurred by you on behalf of the company should be reclaimed from your company and will attract no tax liability.

All reimbursed expenses will need to be reported on your P11d by the company and any that were actual benefits in kind and not business related will attract a tax charge.