Contractors who contract through their own limited company and whose contracts are outside IR35 will generally find taking a dividend and minimal salary the most tax efficient method of extracting contracting earnings from their company.
Dividend tax changes were introduced in April 2016 that have increased the marginal rate of tax on dividends by 6% for contractors. Despite these changes, operating a dividend/salary split remains more tax-efficient than paying a salary.
The tax bands for dividends are 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers. There is also a Dividend Allowance of £5,000, which isn’t an allowance in the traditional sense but rather a zero rate band. This is one factor which has served widespread misunderstanding and complicated the dividend tax calculation.
Calculating income tax on dividends
Although contractors are no longer required to gross-up their net dividend to determine which tax band the dividend falls into, calculating the tax due on dividends can still be complicated.
Contractors who want to calculate their income tax payable on dividends can use the our Dividend Tax Calculator. And if you want to work out how much more tax you are going to pay on dividends due to the changes you can use our dividend changes calculator.
But to show how the final tax figures are calculated, here is an example.
The dividend tax rates for tax year 2016/17 are as follows:
Contractors must be aware that these rates are income tax rates applicable to all earnings and are not isolated to just dividends. As such, a contractor operating a salary/dividend split needs to account for the amount of salary withdrawn when calculating their dividend tax. Likewise, contractors with buy-to-let investments will need to include their rental income.
Looking at an example of a contractor whose total earnings take him/her above the higher rate of tax, a contractor deciding to pay a dividend of £60,000 plus a basic tax-free salary of £8,060 would pay £10,169.50 in income tax.
How did these figures arise? To keep things simple, let’s say the contractor made a profit of £75,000, on which £15,000 in corporation tax at 20% is payable. That leaves a profit of £60,000, which the contractor decides to take as a dividend.
On top of this, the contractor opts to pay themselves a salary of £8,060, based on the 2016/17 National Insurance Contribution (NICs) thresholds. This salary is not taxed, nor does it attract NICs.
The personal allowance for the 2016/17 tax year for individuals whose annual income doesn’t exceed £100,000 is £11,000. This means the contractor can carry over the remaining tax-free £2,940 (£11,000 - £8,060 = £2,940) into their dividend income.
Having used up their personal allowance, the contractor can take out £32,000 more in dividends before entering the higher rate bracket. What the Government has chosen to refer to as a £5,000 Dividend Allowance is in fact a zero rate band, meaning it eats into the usual income bands. This effectively means that the basic rate band shrinks to £27,000 whilst £5,000 is taken tax-free.
The £27,000 is taxed at 7.5%, incurring £2,025 in tax. This leaves £25,060 in dividends which exceed the basic rate and fall within the 32.5% higher rate, incurring £8,114.50 in income tax. So based on a £60,000 dividend and £8,060 salary, a contractor would receive an income tax bill of £10,169.50.
( * denotes that the £5,000 Dividend Allowance has been taken from this band tax free, leaving £27,000 to be taxed at 7.5%)
And that is how the so called "much simpler dividend tax regime" works!
The example above is a very simple case. If you have other earnings then those will need to be taken into account. The trick it to establish the starting point within the basic rate bands at which dividends are going to be taxed - then apply the zero rate for the Dividend Tax Allowance, and then apply the dividend tax rates.
Or, there is a much simpler way - just use our Dividend Tax Calculator, which always incorporates up-to-date allowances!
Reducing personal allowances
Another aspect which makes the calculations complex is the reducing personal tax allowance for anyone earning over £100,000 pear year.
For example, if a contractor’s tax code is 1100L, their personal allowance will be £11,000. However, contractors with this tax code who earn over £100,000 per year also get hit by the reduced personal allowance introduced in the 2010 Budget. It is important for contractors to consider their total taxable income and account for any adjustments to their personal allowance before calculating their dividend tax. You can find out about personal tax codes and how they work here.
The personal allowance reduces by £1 for every £2 over £100,000 earned, so everything a contractor earns over £100,000 is effectively taxed at 60% up to £122,000. After this point the entire allowance (assuming a tax code of 1100L) is wiped out whilst the contractor will have effectively paid 20% extra tax on the £22,000 that exceeds £100,000.
To put this into context, a contractor earning over £100,000 a year works every day until lunchtime for the Chancellor before they start to pocket any money themselves. It is worse for employees earning over £100,000, who still have to pay 2% employees NI, making their effective marginal rate 62%.
If a contractor is hovering just above the threshold, then a very effective option is to share dividends with a spouse or civil partner by splitting dividends, or paying a salary – thus lowering their tax liability on dividends.
However, contractors attempting to lower the tax they pay on dividends this way must ensure their spouse or civil partner qualifies for a 'spousal exemption' from the settlements legislation (formerly known as Section 660). Otherwise HMRC may consider applying the legislation which treats the spouse’s income as if it were the contractor’s and apply income and dividend taxation accordingly.
And one final tactic of reducing the impact of the "reducing allowance tax bump" of 60% is to avoid going over it every year. If for example your total earnings including salary and potential dividends were £125,000 per year, then rather than pay taxes on £125,000 each year it would be better to manage dividend declarations so they alternated between £100,000 one year, then £150,000 the next, and then back to £100,000 again. If you are going to go over the bump, basically try not to do it every year.