How can you be tax-efficient when paying yourself dividends from your limited company?
Posted on 7th Sep 2022
How to be tax-efficient whilst paying yourself dividends from your LTD...
If your business is a limited company, then one way to pay yourself is by way of dividends. For many business owners being paid a mix of salary and dividends is one of the most tax efficient ways to legitimately take money out of the company.
Someone will typically pay less tax if they are paid by a combination of salary and dividends as opposed to being paid either just salary or just dividends.
Salary is paid because the business owner is an employee of the company whereas dividends are paid when they are a shareholder.
In this article I will answer one of the most common questions I get asked by business owners which is ‘How much dividend can I pay myself from my limited company, whilst being tax-efficient?’.
Let’s get started….
What are dividends?
A dividend is a payment made to a shareholder (ie owners) of a company.
In the same way that a salary can only be paid to an employee, dividends can only be paid to a shareholder. If someone is not notified as being a shareholder at Companies House then they cannot be paid a dividend.
Dividends can only be paid out of the retained profit of a company.
Retained profit is the total amount of profit the company has ever made after corporation tax has been deducted AND which has not already been paid out to the shareholders by way of dividends.
Retained profit is an important number which can be found in the ‘Capital & Reserves’ section of the Balance Sheet report in either the Annual Accounts or monthly Management Accounts.
What tax do I pay on dividends?
All dividends received form part of an individual’s income for the year. As such they have to be declared on their Self Assessment Tax Return.
The tax paid by an individual on their dividends is called ‘Dividend Tax’.
Which tax rate is applied to the dividends received will, broadly speaking, depend on, firstly, what someone’s income is and, secondly, how much dividend they received.
The dividend tax rates for 2022/23 are as follows:-
· Basic-rate taxpayers pay 8.75%
· Higher-rate taxpayers pay 33.75%
· Additional-rate taxpayers pay 39.35%
As an aside.
You might end up paying tax on your dividends at more than one rate. It all depends on what your dividend income and total income figures are.
How much dividend can (or should) I pay?
When deciding how much dividend can (or should) be paid to the shareholders there are several factors which should first be considered….
1 - Retained Profit
As mentioned above the retained profit is amount of profit which has not yet been paid out to shareholders by way of dividends.
Whatever this retained profit amount is then this is the maximum dividend that can be paid.
IF a company makes more profit….
- Then there is likely to be more retained profit in a year meaning higher dividends payments could be made.
IF a company makes less profit (or even a loss) in a year….
- Then there is likely to be less retained profit meaning lower dividends payments could be made….and if the company has no retained profit then no dividends can be paid.
It is illegal to declare a dividend if:-
- A company has no retained profit (because it made a loss in the past)
- A company’s retained profit is less than what the business owners wants the dividend to be
2 - Tax-free Allowances
Probably the most important factor to consider when it comes to being tax efficient is for someone to take advantage of all the tax-free personal allowances.
- For income tax : the first £12,570 (for 2022/23) of ALL income is income tax tax-free
- For dividend tax : the first £2,000 (for 2022/23) of dividends is dividend tax-free
This means that a business owner (who receives a combination of salary & dividends AND has no other income) can potentially earn £14,570 and will pay no income tax nor dividend tax.
3 - Income Tax Thresholds
One way to be tax-efficient is to declare dividends which take your total income to just under (but not beyond) an income tax threshold. By ensuring your income doesn’t exceed the threshold you avoid paying higher rates of tax.
Important income thresholds to be mindful of for 2022/23 are as follows:-
- Personal Allowance (tax free) £0 to £12,570
- Basic-Rate Income Tax £12,571 to £50,270
- Higher-Rate Income Tax £50,271 to £150,000
- Additional-Rate Income Tax £150,001 +
Let’s illustrate the importance of knowing these thresholds with an example.
Amy has earned salary and dividends thus far of £45,270 and, whilst she doesn’t need the extra money, is planning to declare a further dividend of £10,000 before the end of the tax year.
There is quite a difference when it comes to the amount tax to pay on this dividend…
1st £5,000 (which takes the income up to £50,270) is taxed at 8.75% = £437.50
2nd £5,000 (which takes the income over £50,270) is taxed at 33.75% = £1,687.50
If Amy doesn’t need the £10,000 cash then it would seem more tax-efficient for her to pay a dividend of £5,000 instead of the planned dividend of £10,000.
4 - Other Important Thresholds
There are 3 other tax and benefit thresholds to be aware of before deciding on how much dividend is to be declared.
a) Loss of Income Tax Personal Allowance
Where an individual’s total income is between £100,000 to £125,140 then £1 of the tax-free income tax
personal allowance is lost at a rate of £1 for every £2 over £100,000.
This means the effective dividend tax rate on dividend income in this band is not 33.75% but in fact 55.75%.
b) Loss of child benefit
Child benefit is a tax-free benefit paid to the parents for each child under the age of 18. It is worth each year – £1,134 (for the eldest child) and £751 (for each additional child).
If either parent has income of more than £50,000 then this tax-free benefit must be repaid – at a rate of 1% for every £100 of income more than £50,000.
For parents an extra dividend could mean losing some/all of this tax-free benefit.
c) Student Loan
Student loan repayments have to be made when an individual’s income is more than the income threshold for their particular plan – Plan 1 threshold is £20,195 and Plan 2 threshold is £27,295.
The amount payable is 9% on any income earned above the relevant plan’s threshold.
5 - Other Considerations
When deciding what dividends to pay you should be mindful of a couple of other important considerations.
a) Income for a mortgage
Thinking of getting a mortgage to move home or re-mortgaging to get a better deal ?
Either way the size of the mortgage you can get will largely depend on your earnings. In many cases mortgage lenders will consider someone’s earnings for the past 2 or 3 years.
If you’re planning on moving house (or getting a re-mortgage) then with careful consideration you can look to improve the likelihood of getting the mortgage you want.
Starting with the mortgage you need you then work out what your incomes need to be and for how many years to get it.
You can make sure you have the income needed in each year by simply declaring the right amount of dividend at the right time.
b) How much cash is needed – now and in the future
It might be that you’ll need a lot more cash that you currently do at some point in the future. Maybe you’re planning on home improvements? Maybe you’ve got a big purchase in mind – a new car or paying for
Without any tax planning you would typically declare higher dividends in the year you need the cash. That could well mean higher rate tax being paid on a large amount of those dividends.
However careful tax planning can often avoid some, possibly all, of that higher rate tax being paid. The planning will assess the future profits of a company and an individual’s cash requirements, over the next few years. Once these figures are known then calculations can be done to work out what is the tax-efficient dividend to pay in each of the next few years.
An important aside…
If a dividend has been declared BUT an individual doesn’t need all the cash then they can ‘leave’ the bit they don’t need in the company.
Invariably that amount is credited to their loan account and stays there until the cash is withdrawn at some point in the future. Since it is repayment of a loan there is no tax to pay on it.
Before deciding how much dividend can (or should) be paid there are several things which should be first considered.
Without looking at someone’s individual circumstances it is quite easy for someone to pay a dividend which is not tax efficient and as a result they would unwittingly and needlessly pay a lot more tax and/or lose a lot of tax-free benefits.