Profit Extraction - how best to draw your living
As a director of a limited company, you have numerous options with respect to extracting funds from the company to meet your personal needs.
Whether you withdraw this money in the form of a salary, dividends or a combination of these, this will carry tax implications. As such, it is important that you plan ahead to ensure you are doing this in the most efficient manner possible.
Paying Yourself A Salary
When paying yourself a salary, any income received above the Personal Allowance for 2020/21 of £12,500* will be subject to tax via PAYE. The Income Tax rates and thresholds from 6 April 2020 are as follows:
Tax Band Threshold Income Tax Rate Basic Rate Up to £37,500 20% Higher Rate £37,500 to £150,000 40% Additional Rate £150,000+ 45%
*Please be aware that for those individuals with income over £100,000, this allowance is gradually tapered down by £1 for every £2 over this threshold. If your income exceeds £125,000 then you will not be entitled to a Personal Allowance in 2020/21.
In addition to this, should the salary you decide to pay yourself exceed £9,500 p.a. (or £792 per month) – you would need to make both employers and employees Class 1 National Insurance Contributions (NIC) in addition to this.
The excess over the threshold of £792 per month would be subject to employers Class 1 NIC at 13.8%. For employees NIC, this works slightly differently. The excess over the same threshold is subject to Class 1 NIC at 12% up until you hit the Upper Earnings Limit threshold of £50,000 p.a. (or £4,167 per month). Any excess over this amount would only be subject to employees Class 1 NIC at 2%.
Whilst this route can appear quite heavy from a tax perspective on the personal Income Tax side, it does carry positive implications on the Corporation Tax side. You can deduct any salaries paid from your taxable profits, giving you a saving on your Corporation Tax bill at 19%.
Paying Yourself in Dividends
Given that Income Tax rates on a salary are quite high (and paying yourself a salary often carries NIC implications) – an alternative route is to pay yourself by way of a dividend.
The Income Tax rates on dividends are not only significantly more favourable, but you also benefit from the dividend allowance – where the first £2,000 of dividends received in a tax year are free of tax. This allowance is used in conjunction with the Personal Allowance referred to above of £12,500.
The Income Tax rates for dividends from 6 April 2020 are as follows:
Tax Band Threshold Income Tax Rate Basic Rate Up to £37,500 7.5% Higher Rate £37,500 to £150,000 32.5% Additional Rate £150,000+ 38.1%
There is no requirement to make NICs in relation to any dividends paid, which can make this route appear more tax efficient. However, it is worth noting that making National Insurance Contributions builds up your entitlements for pensions or maternity allowance – so it is important you are making these on an annual basis.
You also do not have the benefit of deducting the value of any dividends paid from your taxable profits for Corporation Tax purposes.
Paying into Your Pension
Another option for remuneration would be to make employer contributions into your pension scheme. This carries no Income Tax implications, as long as the total combined pension contributions within the tax year (including both employer and personal contributions) do not exceed the annual allowance of £40,000.
Please be aware that this allowance can be tapered down once your ‘threshold income’ levels exceed £200,000 within the tax year. Threshold income refers to your earnings (plus investment income), less any personal pension contributions made in the tax year.
If your threshold income exceeds £200,000, then if your ‘adjusted income’ exceeds £240,000 – your annual allowance is tapered down by £1 for every £2 over the adjusted income limit. Adjusted income refers to your earnings (plus investment income), including the value of any personal pension contributions made.
This can be tapered down to a minimum of £4,000 (for those with ‘adjusted income’ levels exceeding £312,000) within a tax year.
This is an option with a long-term focus – given that because money is being put into a pension scheme, you would not be able to access these funds until you reach the age of 55.
In practice, the best option is often a combination of the three.
Whilst Income Tax rates on your salary are relatively high, it is important that you are mindful of making sufficient National Insurance Contributions on a yearly basis in order to build up your entitlements for your state pension and maternity pay.
A common planning technique is to pay a salary up to the Primary Threshold of £9,500 p.a. – meaning you do not have to make any NIC payments, whilst also building up your entitlements. This salary amount would also be covered by your personal allowance of £12,500 – freeing up your basic rate band to make use of the dividend tax rate of 7.5% - giving a significant tax saving.
This does however reduce any relief you would receive by reducing your taxable profits for Corporation Tax purposes.
In reality, to achieve maximum tax efficiency we would need to take a look at the entire picture. Many individuals receive other streams of taxable income other than from their own business, which would affect the strategy that should be put into place. It is also important to consider the tax position of the company itself.
It is also a great idea to make use of this opportunity to make contributions into your pension scheme – so this should not be overlooked.