Dear Contractor Doctor
I have been contracting for over two years now and have now amassed a sizable amount of money in my company and am considering paying off my mortgage.
However, I’ve been advised by my accountant that I will pay higher rate tax on any dividends over my basic rate band. So, I am unsure whether I would be better off reducing the interest bill on my mortgage by paying it off early, or saving the income tax and keeping the cash in my company for the future, whilst continuing to make my normal mortgage repayments.
Should I keep surplus cash in my company or pay off my mortgage?
Contractor Doctor says:
“Each limited company contractor’s circumstances are different, and when considering savings and investments, it is essential for contractors to seek expert advice from a qualified financial adviser,” explains James Abbott, owner and head of tax at contractor accountant Abbott Moore.
“However, we cannot predict what the future tax rate will be, so there is no guarantee that a contractor is better off deferring dividend decisions. And, even with the current record low interest rates, paying-off mortgages early may offer the best route to increasing your wealth when compared to many investments.”
Construct the right thought processes to help decide
“Contractors should start by constructing the right thought processes on the decision,” he continues. “Imagine that the company earns £100 which, assuming the company is in profit, leaves the contractor with £80 after corporation tax.
“The contractor then has a choice. They can keep the £80 in their limited company, bearing in mind that there is little that they can do with it to increase its value, particularly with larger actively managed sums left within the company threatening the tax advantages of being a trading rather than investment company. Or they can declare an £80 dividend, pay £20 income tax and be left with £60.”
Abbott’s view is that, for many contractors, holding onto the money is delaying the inevitable, and there is likely to be little difference between taking the dividend and paying the income tax now, or in three years time.
It is notoriously difficult to predict future tax rates
There are the further complications for the contractor to consider. Abbott explains: “Future tax rates are dependent on two variables: the contractor’s income and the tax rate. Is the contractor currently earning particularly high fees, which are likely to fall in the future, or are the contractor’s earnings likely to increase?
Abbott highlights that predicting future tax rates is fraught with uncertainties: “Who would have predicted a 50% top rate of tax would come in for the highest earning contractors during the contracting boom years of the early and mid-noughties?”
The same is true of capital gains tax. “Many contractors look on the 10% tax rate available under entrepreneurs relief as the holy grail,” notes Abbott. “But the rules could easily change in the future, as we saw with ESC C16.”
There are further complications, such as if the contractor were to get married. This may offer the opportunity to income split, which in itself must be delicately handled so the new spouse doesn’t fall foul of HMRC’s settlements legislation.
Paying a mortgage can make financial sense
“Consider a contractor seeking to retire in five years time. They can’t do anything about corporation tax, so their £100 earnings will become £80,” says Abbott. “The contractor can choose to take the money now and receive £60, or they can leave the money in the company and extract it in five years time using entrepreneur’s relief, and get £72 (90% of £80).
“But if you look at the mortgage example, if the contractor pays themselves the £60 to pay off, or off-set, the mortgage, and the mortgage interest rate is 5%, they save the 5% of the £60 paid off the mortgage each year. Furthermore, the interest saved isn’t taxed so it is additional money in the contractor’s pocket.
“Over five years, the contractor’s retirement timescale, the £60 would ‘grow’ by 5% per annum. The result is that the contractor ends up receiving £76.57 for their original £100 in fees, so all other things being equal, the contractor is better off paying off their mortgage rather than storing up the cash.”
Contractors are strongly advised to speak to a chartered tax advisor before making plans, so all medium and long term plans can be considered.