Most effective 2018-19 dividend and salary combination

The tax rules for dividends changed several years now ago.  As the new tax year has started, we thought we'd detail the most effective 2018-19 dividend and salary combination.

Most efficient 2018-19 dividend and salary combination

This article assumes that you are not a Scottish taxpayer. Scotland has different rates of income tax for non savings income (e,g, earnings). However just to confuse matters the same higher rate threshold applies to dividend income.  

Most effective 2018-19 dividend and salary combination: 

New rates

The personal allowance has increased to £11,850 and the basic rate tax threshold has risen to £46,350. Unfortunately though, the dividend allowance has now been reduced from £5,000 to £2,000. You can find further details about tax rates and allowances on HMRC's website here.

Therefore any dividend income greater than £2,000 will be taxed as follows:

  • If you have any unused personal allowance (£11,850 for 2018/19) then that element is tax free
  • Any dividends in the basic tax band (up to £46,350 for 2018/19) attract a tax charge of 7.5%
  • Dividends in excess of the basic tax band are charged at 32.5%
  • A rate of 38.1% will apply to dividends falling within the additional rate band (income above £150,000 for 2018/19).

As a result of the changes, If you are basic rate taxpayer, and you receive all your income in dividends you will be up to £2,438 worse off!

Most effective 2018-19 dividend and salary combination:

Latest strategies

So now that we know the latest allowances and rates, how does this effect the most effective 2018-19 dividend and salary combination?

Taking a modest salary and the balance as dividends has long been the most tax effective form of profit extraction for limited company contractors, freelancers and owner managed businesses.  The reasoning is as follows:

  • You draw a salary at a level below the personal allowance (so no PAYE is due) though high enough to trigger a national insurance record for your state pension. This is frequently at the lowest level so no national insurance is actually payable).
  • Your company obtains a deduction for the salary in it's accounts - so corporation tax is saved at 19% of the gross salary paid.
  • Dividends are then declared up to the level of post-corporation tax profit available in the company. However, don't forget dividends are declared after tax and there's no corporation tax saving on dividends.
  • No National Insurance is payable on dividends. 
  • As it's not necessary for your company to pay all post tax profits as dividends in any one year, dividends can be managed keeping your personal tax liability to a minimum.

Essentially there are now two strategies when determining the most effective 2018-19 dividend and salary combination. Which strategy you choose will depend on whether or not you claim the employment allowance.

The Employment Allowance can currently be claimed where there are two directors who are husband and wife.  This may be challenged by the taxman if both husband and wife can't prove they work actively in the business.

Most effective 2018-19 dividend and salary combination

Strategy 1 - take a salary below the NI primary threshold

If you want to keep things straight-forward, or are worried about claiming the Employment Allowance, then we think this is the best strategy. It's the one we recommend to most of our clients.

The two main National Insurance thresholds you should be aware of are as follows:

  • The lower Earnings Limit.  As long as you earn above this you are protecting your entitlement to future state pension and benefits, without necessarily paying any National Insurance
  • The primary threshold – If you earnings are above this threshold you'll start paying National Insurance (£8,424 for 2018/19)

We'd therefore recommend paying a salary up to the primary threshold

You could then draw dividends of up to £37,926 without having to pay any higher rate tax (basic rate band of £46,350 less salary of £8,424).

However you will have basic rate tax of £2,438 to pay which is calculated as follows:

  • Personal allowance - £11,850 (£8,424 for salary and £3,426 against dividends)
  • £2,000 tax free allowance for dividends - meaning £32,500 dividend income is taxable (£37,926 total dividends less £3,426 from personal allowance less £2,000 tax free allowance)
  • Tax to pay of £2,438 (£32,500 at 7.5% tax rate)

This means you'll have a 'take home' amount of £43,913 (£8,424 salary + £37,926 dividends less £2,438 tax payable).

Additionally, you'll save corporation tax of £1,601 (£8,424 * 19%) by using this strategy.

Strategy 2 - Claim the employment allowance

This strategy won't be available if the only person on the payroll is a single director. It could also be quite risky if you are a husband/wife business as mentioned above.

This strategy is also not effective if the employment allowance is already used against the employer's NI due on the company's other employees.

In the example we'll assume this is a sole director with other employees and there is excess employment allowance to use against their income.

In this case the recommend salary would be an amount up to your personal allowance (£11,850 for 2018/19.

If you have the full personal allowance then you could take a £11,850 salary and a dividend of £34,500 without paying any higher rate tax. This salary/dividend combination would take you up to the higher rate threshold.

However, there will be basic rate tax and employee's national insurance of £2,849 to pay which is calculated as follows:

  • Employer's National Insurance - £473 (being £11,850 less Primary Threshold (£8,424) = £3,426 *13.8%) . We'll assume Employee's National Insurance assume all covered by employment allowance so there is nothing to pay
  • Personal allowance - £11,850 (all used against salary)
  • £2,000 tax free allowance for dividends - meaning £32,500 dividend income is taxable (£34,500 total dividends less £2,000 tax free allowance)
  • Tax to pay of £2,438 (£32,500 at 7.5% tax rate)
  • Employee's national insurance payable on salary - £411 (£11,850 less £8,424 = £3,426 * 12% (assuming NI letter = A))

In this case, you'll have a 'take home' amount of £43,501 (£11,850 salary + £34,500 dividends less £2,849 tax payable

Additionally, you'll  save corporation tax of £2,252 (£11,850 * 19%).

Most effective 2018-19 dividend and salary combination: Summary

So overall, the second strategy will save you £240. However you would need to remember to pay the employee's national insurance to HMRC (and this benefit will be reduced if you’re not entitled to the employment allowance).  

This can be a headache if you don't have any other PAYE deductions to make to HMRC.  The cash flow benefit is also realised more quickly with the first strategy which is only available to single director companies.

For more useful information, check out our Ebooks here.

And if you'd like to know how we can help you with all of this, or with anything else, feel free to give us a call on 01202 048696 or email us at richard@tfaaccountants.co.uk.

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