In a previous article, Drawing money from your Company: Wages, we covered the advantages and disadvantages of adding yourself to the payroll of your limited company. In this aricle, we will be covering the alternative method, which is paying yourself a dividend.
The main advantage of drawing a dividend is that they are taxed at a lower rate than wages. The basic rate of tax for dividends is 7.5% while other income is taxed at 20%. For the higher rates of income, this increases to 32.5% and 38.1% while other income goes up to 40% and 45%.
There is also an additional 0% tax band of £5,000 for dividends. This is not to be confused with an allowance though. Where your regular personal tax-free allowance does not count towards your basic rate band income, this £5,000 does. Therefore, if after other income you have £15,000 left in your basic rate band and earn £20,000 of dividend income, £5,000 will be tax-free, £10,000 will be charged at the basic rate and the remaining £5,000 will be charged at the higher rate.
Please note that from the 1st of April 2018, the 0% tax band will be reduced to £2,000 per year.
The main disadvantage of using dividends is that they are not seen as an expense, therefore they will not reduce your profit or corporate tax bill in the same way wages will. You will also have to register for self-assessment and complete income tax returns for your dividend income each year. This makes you responsible for your own tax while with wages the company will pay your tax on your behalf. You may even have to make payments on account depending on the amount of tax due.
Another disadvantage is that as no NICs are paid on dividend income, your state pension and other benefits may be affected if you only pay yourself through a dividend. Finally, if other people have shares in your company they will also have to be paid a dividend amount proportional to the shares they own. For example, if they own fifty percent of the company they will have to be given the same amount as you if you own the other fifty percent.
Which method works best?
As both wages and dividends have their advantages and disadvantages, it is difficult to say one is better than the other. Normally a combination of both yields the greatest tax savings depending on your self-assessment situation.
Pre-April 2016 dividends
Dividends drawn before the beginning of the 2016-17 tax year were treated differently for self-assessment. They were taxed at 10% then 32.5% and 37.5%, however, they were treated as being taxed at source at 10%. This meant that is you had £900 of dividend income it would count as £1,000 with 10% tax deducted.
This way was changed due to the disproportionate tax savings that made forming a limited company substantially more tax-efficient than being a sole-trader. Now the two are a lot more in line in terms of tax.
If you would like any advice or assistance regarding the above please do not hesitate to contact us.