When it comes to extracting profits from your SME company, recent changes to the way dividends are taxed could make you think twice before going down this route in the future. With the dividend tax rate cut from £5,000 to £2,000 in April of this year, Acumen explores the various options open to you going forward.
What are the new dividend rules?
As of April 2018, the dividend allowance was slashed from £5,000 to £2,000. How that will affect you financially entirely depends on which tax band the first £5,000 of dividends fall into. If they fall into your basic rate band, following the reduction in allowance you will now be £225 worse off. However, if you’re a higher-rate taxpayer, then that figure rises to £975, and for additional-rate taxpayers it’s £1,143.
As such, when it comes to choosing how to take your profits, the focus has shifted towards pension contributions over the past two years. If you don’t need the income for your daily expenditures, then employer pension contributions become a tantalisingly tax efficient means of profit extraction.
Extracting money from a limited company
Despite the new dividend tax rate, dividends are still preferable to drawing a salary for most directors who withdraw profits well above the annual dividend allowance. For higher rate taxpayers, the combined effect of a dividend tax rate of 32.5% and corporation tax at 19% will still yield a better result. A salary option would need to account for the 40% income tax band, employer National Insurance (NI) of 13.8% and employee NI of 2%.
Having said that, pension contributions remain the most tax efficient way of extracting profits from a business overall. Like dividends, an employer pension contribution incurs no employer or employee NI liability and it’s usually an allowable deduction for corporation tax, like a salary. Furthermore, directors aged over 55 will be able to access it as easily as a salary or dividends. With 25% of the pension fund available tax-free, it can be extremely tax efficient, especially if the income from the balance can be taken within the basic rate.
Pension extraction forecast
In all likelihood, many SME business owners will pay themselves a modest annual salary of around £8,000 a year. Neither employer or employee NI is due at this level but credits are earned towards the State pension. The remainder of the annual income can then be taken via dividends for the greatest tax efficiency. However, what about profits earned over and above a director’s day to day living needs?
Based on £40,000 of gross profits, it is actually possible to almost double your pension pot’s value. When taking money from your pension to support your income needs, the figures compare favourably. Assuming the £40,000 fund is taken as a basic rate taxpayer, then your net spendable income will be £34,000. If taken as a higher rate taxpayer, it will be £28,000. Those are 55% and 28% more than the dividend option respectively.
These figures assume that your pension income is taxed after taking 25% of tax-free cash, and that there is no Lifetime Allowance charge. Growth has also been ignored. A further bonus is that, if not withdrawn for income purposes, the full £40,000 could be paid to your loved ones tax-free should death occur before 75, or at your beneficiary’s own marginal rate of income tax.
Tapered Annual Allowance
If you’re a high earning business owner, you could see your annual allowance (AA) tapered down to just £10,000. However, by reducing what you take in dividends or salary, and paying a larger pension contribution, you could still retain your full £40,000 AA. This is because these kinds of contributions are not viewed as salary sacrifice, which means they won’t count towards ‘threshold income’.
For more information about the new dividend tax rules, or to discuss the most efficient profit extraction strategies for you and your business, call Acumen today on 0151 520 4353 or email us at firstname.lastname@example.org.