What is the most tax efficient way of paying yourself?

When it comes to getting your rewards for the work you do, paying yourself and not the tax man is top of the list

For many new small business owners, the prospect of paying yourself is a new one. As years or even decades of being a salaried member of staff at another business comes to an, often abrupt, end one must keep up your income as your home bills and outgoings keep on coming. Often this results in paying yourself like you had been paid before, in the form of a monthly salary being taxed income tax and National insurance as you go and for the most part this goes without a hitch. However as you no doubt become more and more successful you may feel like paying higher bands of income tax even though you are your own employer may seem slightly counter intuitive. Which leads into the question: “What is the most tax efficient way of paying myself?”

For a long time the best way of paying yourself has been a mixture of salary and dividends. Dividends (assuming your company is profitable) are the distribution of profits by the company to its shareholders which in a privately owned company is almost always the founders and owners i.e you. Profits of a company are taxed at a rate of 20% for a company under the small profits rate which is £300,000 (2012/2013) so any money available for dividends payment will be taxed and paid for by the company. Although dividend income tax is 10%, it comes with a tax credit of 10% which, in effect, cancels out the income tax. The reason being that it would be taxed twice (once when it becomes profit and another when it is distributed to the shareholders). Coupling this with the fact that National insurance is not applicable to dividends this makes a tax efficient way of paying yourself up. Dividend payments have some drawbacks. Firstly, it can only be paid out of the company’s profits and secondly, it directly reduces the equity of the company.

Every individual has a personal allowance that can be earned every year without paying tax on it. Using the PAYE system this equals £7,488 a year or £624 a month. Paying this will maintain your entitlement to the basic state pension. As wages are paid before corporation tax then the 20% tax that would have to be paid if the money was paid in dividends is bypassed under the PAYE system. Another aspect of the PAYE system is the amount of help provided by the government for paying the correct tax.

Most business owners will pay themselves with a combination of the two to gain the benefits of both For example, If there was a total of £50,450 to be paid from the business over a year, the most tax efficient way of paying this out would be with 12 monthly payments in the form of a wage of £624 (£7488/year) with the remainder (£42962) taxed as a profit of the company under corporation tax (£42962 – 20%=£34,370) and paid in dividends. This creates a net income of £41,857 with an effective tax rate of 17%. If this had been paid out entirely as a salary the tax rate would have been closer to 30%.

As you can see, it pays to be in the know   about tax. In the example above the person saves over approximately £6100 a year. Coincidentally (or not), after £50,450 the person would have no choice but to pay dividend tax as after £34,370 the tax rate increases to 32.5%, however the tax credit remains making this effectively 22.5% tax.

As ever, any questions or queries about any tax issues, we are more than happy to help here at Affordable Accounts. Call us on 01942 356681 for a chat or to book an appointment either at our offices or elsewhere.

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