Salary Versus Dividends 2018-2019: Which is Best?

 In Contractors & Freelancers

Before you decide whether to incorporate, it pays to understand the difference between being paid with a salary or through dividends.

One of the main reasons people move from being a contractor to a limited company is the chance to optimise their tax liabilities by moving much of their income into dividends. While recent changes to tax law have altered that calculation a little, that still holds true.

Salary versus dividends

When you set up as a limited company you will be a shareholder and a director who works for the company. As such, you will be an employee entitled to a salary as well as the main shareholder entitled to be paid dividends on corporate profits. These have traditionally been seen as a more tax efficient way of being paid.

Contractors who become limited companies would look at a low salary/high dividend combination to reduce the proportion of their overall income which goes back to the taxman. However, dividend tax increases which took effect in April 2016 have made dividends a little bit more expensive.

The move was specifically to reduce tax motivated incorporation and moves from a situation in which contractors would gross up their dividends to a new one in which they pay a simple rate on net dividends. These run as follows:

  • Ordinary rate: 7.5% on earnings up to £34,500
  • Higher rate: 32.5% on earnings up to £150,000
  • Advanced rate: 38.1% on taxable income over £150,000

If your spouse is also a shareholder in your limited company you can also split your dividend income to reduce your combined tax liabilities and increase income.

How salaries are taxed

The current income tax thresholds are as follows.

  • Personal allowance: Incomes up to £11,850 pay 0%.
  • Basic rate: From £11,851 to £46,350 you pay 20%.
  • Higher rate: £46,351 to £150,000 pays 40%.
  • Over £150,000 pays 45%.

The big difference between the two is that, unlike a dividend, salaries are subject to national insurance. All earnings between £8,424 and £46,356 are taxed at 12%. Beyond that, they are taxed at 2%. Above £8,424 there would also be 13.8% employers national insurance to pay by your company.

Where to set them

The question will be: how should you split salary and tax dividends? In general, people will look to keep salaries low – as close to the personal allowance threshold as possible. So, for example, you might choose to set your main pay at £11,850 to benefit from the full 0% tax band or at £8,424 to benefit from the 0% NIC band also.

There’s also another issue which high earners might have to consider. If your income as a contractor exceeds £100,000 your personal allowance starts to shrink. For every £2 over the £100,000 threshold you are paid, your personal allowance falls by £1.

How an accountant can help

The rules and thresholds can make things complicated and they are shifting all the time. Fortunately, if you use an accountant, or outsource your tax to an accountancy firm, you will never have to get involved with them. They can ensure you comply with all your obligations and advise you on the optimal way to structure your income. As well as keeping all the details in order, this frees you up to concentrate on the more immediate challenges of driving your enterprise forward.

The decision of whether or not to move from being a sole trader to a limited company can be a difficult one. They both come with their own advantages and disadvantages but understanding the real difference between dividend and salary income will help you decide on the best way forward.

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