As an owner of a limited company you are no doubt used to paying yourself (and any other shareholding directors) through a mix of salary, dividends, and perhaps a bonus, with the salary element being paid at a level that sits just below that which would trigger employer and national insurance contributions.
With the well-publicised (and disappointing) changes to dividend tax announced by the Chancellor in his Summer Budget, you may well be wondering if this low salary / high dividend strategy remains the most tax efficient method of remuneration for you as a business owner.
At the heart of the proposed changes is the removal of the 10 percent notional tax credit (more on this below) so in future all dividend income will be treated as gross i.e untaxed income, and the introduction of a £5,000 ‘dividend allowance’.
This allowance means that you will pay no tax on the first £5,000 of dividends – working in a similar way to the tax-free personal allowance for PAYE income.
Over and above the £5,000 however, dividend income will be taxed in three familiar bandings:
The 10% notional tax credit is a little confusing but it has essentially meant that, for every £1,000 of dividend income received, it is assumed that £111 of basic rate tax has already been paid (the gross dividend is therefore £1,111).
This is why basic rate taxpayers have not had any further tax liability on the dividends they received.
And, for higher rate taxpayers, the notional tax credit has meant an effective dividend tax rate of 25%, and a rate of 30.56% for additional rate taxpayers.
With the introduction of the new dividend tax bands above, basic rate taxpayers will now however find themselves paying a tax of 7.5% on all dividends over £5,000.
Higher rate taxpayers will see their tax increase from 25% to 32.5%, and those in the top earnings band will see their tax bill on dividends rise from 30.56% to 38.1%.
The examples in this table show how the tax will affect each level of taxpayer. We have based this example on a monthly dividend of £3,000 and compared the current financial year with the next financial year, when the changes will come in.
You can see that all taxpayers are adversely affected by the new dividend tax, as highlighted in red.
Dividends have historically attracted a much lower rate of tax than PAYE income. This is because dividends are paid out of company profits, which have already been subject to corporation tax. With the recently announced changes, dividends still sit below the tax rates for PAYE income – but the gap is most definitely closing.
Taking into account both the company and the personal tax implications of the dividend changes, you will still pay less tax if you pay yourself through dividends, rather than switching to salary alone. So a low salary / high dividend remains the most tax-efficient option – but your tax bill is likely to rise.
Unfortunately, and despite HMRC’s claims that many business owners will see smaller tax bills, the reality is that director-shareholders of most small owner-managed businesses will end up paying more tax.
A short-term and one-off solution is to take next year’s dividends in the current year. This will ensure your dividends are taxed under the current regime. Note that the company must be able to afford for you to do this – talk to your accountant to avoid risking ‘overdrawing’ your dividends.
Future years will then be paid at the new rates of tax.
If you are approaching retirement – and can afford a smaller take-home amount – then it makes sense, from a tax perspective, to divert some of the planned dividend income towards your company pension.