“How do I pay myself a tax-efficient income from my business?”
After spending lots of time and energy growing your business, you might have reached the stage where you want to reap the rewards of your hard work.
This short blog will help you to understand:
“What’s the most tax efficient way to draw money from a ltd company?”
“Should I pay myself in dividends or salary?”
“Are company pension contributions an allowable expense?”
Income options for business owners
Deciding how to pay yourself can be a bit of a minefield. However, it’s possible to make your business highly tax-efficient by structuring the way you extract money.
Financial planning for business owners is extremely important. By using a combination of salary, dividends and pension contributions, you can reduce your company’s tax bill and improve your current and future finances.
I’ve outlined below how to take tax-efficient income from your business, however, if you’re looking for a financial planner near Bath, please get in touch.
Pay yourself a salary
A salary tends to be the simplest way to pay yourself. You get a regular income, which makes personal budgeting easier, and it comes off your company’s normal payroll run.
Some other benefits of paying yourself a salary include:
It’s an allowable business expense, so it can reduce the amount of Corporation Tax your company pays
You can pay yourself a salary even if your business isn’t making a profit
It can make it easier for you to be approved for a mortgage and other loans.
On the other hand, taking a large salary isn’t always the most tax-efficient method of extracting income from your business. For the 2020/21 tax year, if your income is more than £12,500, you’ll pay Income Tax at 20%. Income of £50,000 to £150,000 is taxed at 40%, and income above £150,000 is taxed at 45%.
Additionally, you’ll pay National Insurance on earnings of more than £792 a month, while your company will pay employer National Insurance of 13.8% on earnings above £732 a month.
Some directors choose to keep their salary below £12,500 to avoid Income Tax, but high enough to still qualify for the State Pension. If you earn between £520 and £792 a month, you won’t pay National Insurance but it might still count as a ‘qualifying year’ when working out your State Pension entitlement.
Take dividends
If your business is making a profit, you might be able to pay yourself dividends.
Unlike salary, neither you nor your business will pay National Insurance on dividends.
You can earn £2,000 in dividends without paying Dividend Tax in the 2020/21 tax year. Beyond this threshold, basic-rate taxpayers pay 7.5% tax, higher-rate taxpayers 32.5%, and additional-rate taxpayers 38.1%. Note that these rates are lower than Income Tax, so extracting income as dividends could help to reduce your personal tax bill.
There are a few things to bear in mind if you’re thinking of paying yourself dividends:
You can’t count dividends as business costs when you work out Corporation Tax
Your company mustn’t pay out more in dividends than its available profits from current and previous financial years
You must usually pay dividends to all shareholders.
Paying yourself dividends can be complex. Speak to an accountant for advice on how to do this correctly and tax-efficiently.
Make employer pension contributions
Another potential downside of paying yourself large dividends is they don’t count as ‘relevant UK earnings’ and therefore won’t be used to calculate your pension tax relief limit. Only your salary will be taken into account.
For the 2020/21 tax year, the pension tax relief limit is 100% of your salary with a cap of £40,000. So, if you earn £20,000 in dividends but only £10,000 in salary, the maximum amount you can pay into your pension and still get tax relief is £10,000.
One way of ensuring you make full use of your £40,000 Annual Allowance is to make pension contributions from your company. Although employer and personal pension contributions both count towards your Annual Allowance, employer contributions aren’t limited by salary.
Making pension contributions can also reduce your company’s tax bill. Pension contributions from pre-taxed company income are an allowable business expense and so don’t attract Corporation Tax. This means a £100 pension contribution only costs your business £81 because of the 19% reduction in Corporation Tax.
Pension contributions are also exempt from National Insurance. In total, your business could save up to 32.8% (19% Corporation Tax plus 13.8% National Insurance) by paying into your pension instead of paying you the same amount as salary.
Under HMRC rules, employer pension contributions must be made ‘wholly and exclusively for the purposes of the business’ to receive relief from Corporation Tax.
Don’t forget your own financial needs and goals
So far, I’ve focused on how to reduce the amount of tax you and your business pay when drawing income. However, tax isn’t everything. You also need to think about your financial needs and goals.
For example, taking a small salary might be tax-efficient but if you’re struggling to make ends meet it’s unlikely to be sustainable. You should think carefully about your current financial commitments when deciding how much, and how often, to pay yourself.
Pension contributions are a great way of building a nest egg for your future. By making employer and personal contributions, you’ll increase your chances of living a comfortable retirement. Each time you make a personal pension contribution, the government adds tax relief of 20%, which can help your pot grow faster.
There are other things to think about too, such as making a will and ensuring your estate doesn’t attract an unnecessarily high Inheritance Tax bill when you die.
A financial planner can help to ensure your business and personal finances afford you the lifestyle you desire now and in the future.
Get in touch
I specialise in providing financial planning for business owner clients, so if you’re looking for a financial planner near Bath and the surrounding areas, please don’t hesitate to contact me. Email daniel@wiltshirewealth.com or call 01225 699790.
Please note
This article is for information only. Please do not act based on anything you might read in this article. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor. All contents are based on our understanding of HMRC legislation which is subject to change.
The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested.
The Financial Conduct Authority does not regulate tax advice.
