Dividend Tax Changes and Profit Extraction in 201613th December 2015
For most company owners, profit extraction simply means salary vs. dividends. There is usually a relatively straightforward way to determine the best salary level, which often ends up being quite low, and pay the rest in dividends. In April 2016 the math will become less simple and less favourable for most taxpayers. The dividend tax changes will make dividends generally more expensive and less attractive as a profit extraction channel.
Dividend Tax Changes Explained
From the 2016-17 tax year, the 10% notional tax credit will be abolished. Having been somewhat confusing and unclear to some small business owners, getting rid of this complicated mechanism is not a totally bad decision by itself.
Instead of the 10% tax credit, an annual dividend income allowance of £5,000 will be introduced. The first £5,000 you receive in dividends will be tax-free. The rest will be taxed depending on your income tax bracket:
- For basic rate taxpayers, dividends beyond the first £5,000 will be taxed at 7.5%. Under the current rules there is effectively zero tax, as the 10% rate is exactly offset by the tax credit.
- For higher rate taxpayers the new rate is 32.5%. Existing effective rate (with the tax credit applied) is 25%.
- For additional rate taxpayers it is 38.1% vs. 30.6%.
It is clear that almost all taxpayers will end up paying more tax on the same dividend income compared to the old rules. That said, merely looking at the rates may be misleading, because unlike now the first £5,000 will always be tax-free. Some higher or additional rate taxpayers may actually end up paying less tax if their dividend income is very small. However, most company owners pay themselves dividends in tens of thousands per year or more and the tax bill for that will go up substantially.
Closing the Gap between Salary and Dividends
It should be noted that even after these changes dividends will remain generally more tax efficient than salary regardless of your tax band.
The existing strategy of many business owners is to pay yourself a salary high enough to fulfil the State Pension criteria (currently £112 a week, or £5,824 a year) and usually a little more to take advantage of the personal allowance (currently £10,600 a year for most, or about £204 a week) and of the fact that National Insurance (paid on salary but not on dividends) only applies beyond the primary threshold (currently £155 a week, or £8,060 a year).
The exact amount of optimum salary depends on a number of factors, but generally for most people it is somewhere around the above listed figures. The rest is usually paid in dividends and for many business owners dividends represent the greater part of their income.
The overall logic will remain the same in 2016-17. The key change is that the gap between effective taxation of salary and dividends will become narrower. Many company owners will find that there is not much they can do about it, other than pay more taxes. However, depending on your age, income and other personal circumstances, you may want to consider a third way to extract company profits: pension contributions.
Pension Contributions as a Profit Extraction Channel
In a way, pension contributions combine the best of salary with the best of dividends. Like salary, there is no corporation tax (employer’s contribution is usually an allowable deduction). Like dividends, there is no National Insurance.
Unfortunately, unlike salary or dividends, it is not money you can use to pay the bills or spend as you wish – at least not immediately. It remains locked in your pension until you are at least 55. Beyond that point, thanks to the new pension freedoms, it can be as flexible as salary or dividends.
Of course, for most people pension contributions are a possible complement, rather than a replacement of salary and dividends. By adding them in the mix, you may be able to reduce your effective tax rate, but there are many other factors you need to consider, such as the Lifetime Allowance, which makes pensions much less favourable beyond a certain level.
This is where profit extraction meets retirement planning. As we always emphasize, no financial decision must be takes in isolation. You should always consider how it will affect other parts of your life and your finances, now and in the future.Share: