Salary, dividends or both? How to effectively pay yourself as a Limited Company contractor

One of the financial benefits of being a Limited Company contractor is having the ability to choose how to pay yourself in the most tax efficient way. The most common way of doing so is by using a combination of dividends and salary, but how do you go about doing this?

Whilst every contractor’s needs are uniquely different – it’s advisable to discuss your own personal requirements with a specialist contractor accountant – if you’re just starting out and need a general overview, then this blog is for you.

What is a dividend?

A dividend is a distribution of company profits to its shareholders. Dividends are only payable if the company has the available profit to do so, and once business expenses, liabilities, tax (including Corporation Tax) and VAT have been paid. They also cannot be in place of payment for work or services. Limited Company contractors typically draw down the majority of their earnings in the form of dividends.

When can you draw dividends?

As the director of your own Limited Company you are able to draw dividends whenever you choose. You decide when is appropriate for the business.

You should minute your decision to take dividends and provide all shareholders with a dividend voucher. Taking these two steps will show an audit trail should you ever be investigated, plus they will be required for your annual tax return.

What are the tax and National Insurance Contributions (NIC) implications?

Dividends don’t incur any NIC, and this is why combining a low salary and high dividends is such a favourable way to pay yourself.

The dividends you draw yourself are taxed as personal income, with a tax-free allowance up to £2,000 per person. with a tax-free allowance of currently £2,000 (2020/21):

Basic rate (7.5%): up to £50,000

Higher rate (32.5%): between £50,000 and £150,000

Additional tax rate (38.1%): £150,000+

It’s also worth understanding that dividends are taxed on the date they’re declared, rather than paid. For example, if you were to declare a dividend on April 1^st but paid April 7^th it would still be included in your tax return for the previous tax year, which could potentially take you over the basic or higher rate percentage.

Always double check with your specialist contractor accountant to make sure you’re doing the right thing before taking any money out of the company, and what the tax implications will be.

How much should your salary be?

You are able to pay yourself whatever you wish! Salaries are classed as an allowable expense to your company, so you’re entitled to tax relief, which ultimately lowers Corporation Tax bill.

If it’s just you in your Limited Company and there is no contract of employment, the National Minimum Wage Regulations do not apply. So effectively you’re able to pay yourself any amount you choose. It is worth considering paying a salary of at least the National Insurance threshold to gain a qualifying year for state pension entitlement.

What are the limitations to a lower salary?

By paying yourself at the NIC threshold you could be missing out on a chunk of your personal tax free allowance, and other benefits you’d only receive with a higher salary.

For example it could affect health and personal accident policies, as they’re calculated in relation to your salary. It’s also worth understanding that to qualify for maternity pay and benefits you must be ‘employed’ and paid accordingly within the National Minimum Wage Regulations, and therefore a lower wage would not satisfy these pre requisites.

When to seek advice

Trying to figure out your combined contractor salary and dividends income can be confusing, and it’s easy to make mistakes. That’s why it’s so important to enlist the services of a specialist contractor accountant who knows exactly what they’re doing, and will help you with the tax planning side of things.

Get in touch today to discuss your individual needs, and find out how SG can help you.