The most tax efficient way to pay yourself and how to maximise your basic rate tax band

Introduction   

What is the most tax efficient way to pay yourself, when you run your own UK company?

In addition, when you are a limited company director, how can you maximise your basic rate tax band in 2022/23?

In this article, we are going to take a look into how to extract profits and be tax-efficient, when you run your own business.

This article has helped plenty of UK contractors understand a lot better how to be tax efficient. When you have a good accountant they will help to guide you here. How to pay yourself tax efficiently is also one of our handy tax tips for contractors and small business owners.

Initial thoughts

Firstly, it seems that the above is not always very well understood.

Secondly, when an accountant takes on new clients, this is something that they do not always fully understand. On many occasions, their previous accountant did not explain this to them very well. What’s more, the method to work this out is not too awkward if you have the right information to hand.

In conclusion, once you have read this through, you should be aware of:

  • what is the most tax efficient way to pay yourself.
  • how you can maximise your basic rate tax band.
  • how to be more tax-efficient when you run your own UK business.

Tips and advice

If you are new to running your own company, there are many things to consider. A good tip is that it makes sense to claim for all of your genuine business expenses. You should also claim for these over the course of each year. This includes both:

  • Rechargeable expenses to your client.
  • Non-rechargeable expenses.

Expenses help to lower your company’s profit. In turn, this results in a lower Corporation Tax bill and more post-tax profits available to you.

Salary payments are regarded as business expenses and these also help reduce your company’s profit and tax. Therefore, from the outset, you should consider what your salary is going to be. Furthermore, you could also consider employing your spouse, if they are going to be helping you run your company.

Besides taking a salary you can also take dividends from your company. Now, before we move on, there are many aspects to paying dividends. These include:

How to gain tax efficiency

One thing that does come up quite often from company directors is:

  • How I can be tax efficient.
  • What is the best way to take money from a UK limited company.

To work the above out, first of all you need to know:

  • What the current tax bands and allowances are.
  • How the above will interact with taxable income.
  • What the current tax rates are.
  • How the above are applied to different sources of income.

In summary, the tax bands and allowances and, indeed, tax rates all change over time. Therefore, if you would like to be tax-efficient, you need to know how your tax bands work and how your income is taxed.

Recent tax changes in the UK 

Although we are looking at the how to pay yourself tax-efficiently and how to maximise your basic rate tax band, let us have a look at some recent UK tax allowance changes.

First example

One recent change was the complete overall of the UK dividend system. Before April 2016, the dividend that individuals received was 9/10ths of the gross. As part of this they received a 10% tax credit. However, from April 2016, the government scrapped this and brought in the tax-free dividend allowance of £5,000. This stayed in place for 2016/17 and 2017/18. In the next tax year in 2018/19, the government chose to reduce this allowance to £2,000. This is now still the case for 2022/23.

Further example

A further example of a recent change is before April 2016 interest income was tax at source (20%). However, after April 2016 you now receive interest tax-free but:

  • Basic rate (20%) taxpayers –they can earn £1,000 interest per year with no tax (therefore this gives a max tax saving of £200 compared with the time before this).
  • Higher rate (40%) taxpayers –they can earn £500 interest per year with no tax (therefore this gives a max tax saving of £200 compared with the time before this).
  • Additional rate (45%) taxpayers -they can earn £0 (they do not receive a tax allowance for their interest).

A brief history of UK tax rates and bands 

First of all, the personal tax allowance and basic rate (BR) tax band usually change every year.

The personal tax allowance is the amount of income that you can earn before you start paying income tax.

The BR band is the amount of income that you can earn, on top of your personal allowance, that will be subject to BR tax.

Most important, over recent years, the standard personal allowance has been increasing. Meanwhile, the BR band has been increasing too. However, this was not always the case, as is shown in the table below.

  • First, please note, in recent tax years in the UK, there have been different allowances and tax rates that apply in Scotland. Wales and Northern Ireland also have their own tax allowances and tax rates, but these currently align with England.
  • Please also note, in recent times, the government brought in separate rates and tax bands for savings. These will indeed need taking into account if you have sizeable savings.

Historical personal allowances and tax rates

Personal allowance Basic rate tax Higher rate tax Additional rate tax
20% 40% 45%
2022/23 £12,570 £0-£37,700 £37,701-£150,000 £150,001
2021/22 £12,570 £0-£37,700 £37,701-£150,000 £150,001
2020/21 £12,500 £0-£37,500 £37,501 to £150,000 £150,001
2019/20 £12,500 £0-£37,500 £37,501 to £150,000 £150,001
2018/19 £12,500 £0-£34,500 £34,501 to £150,000 £150,001
2017/18 £11,850 £0 -£33,500 £33,501 to £150,000 £150,001
2016/17 £11,500 £0 -£32,000 £32,001 to £150,000 £150,001
2015/16 £11,000 £0 – £31,785 £31,786 to £150,000 £150,001
2014/15 £10,600 £0 to £31,865 £31,866 to £150,000 £150,001

Please note, a blind person receives an extra tax allowance and this is:

2021/22   2,520
2022/23   2,600

Current allowances and future thoughts

In 2022/23, the total that you can earn, which is the earnings limit before paying tax, is your personal allowance of £12.570. The basic rate tax band is £37,700 and if we add this to the personal allowance it gives a total of £50,270. This amount is the income limit before you start to pay higher rates tax.

As shown above, the income tax rates for basic rate of 20% and higher rate of 40% have been consistent over recent previous tax years. These are the rates of income tax that are applied to earned income (salaries, self-employment profits etc). The rates of tax that are applied to dividends are different because dividends come under investment income.

In the future, the personal tax allowance and BR tax band will carry on evolving. What’s more, when you are running your own business, it is good to know what you can earn to maximise your basic rate tax band. As part of this, you will learn what tax you will need to pay in the future and how you can pay yourself tax-efficiently.

The most tax efficient way to pay yourself -2022/23 tax year 

When you consider the most tax effective way to take money out of a company, you could take the full £50,270 basic rate earnings in 2022/23, and stay within your BR band. Please note however, your company needs to be earning enough profit to be able to pay you the £50,270.

As mentioned, the maximum that an individual can earn in 2022/23 before paying higher rates tax is £50,270. There are however certain tax reliefs that can reduce your taxable income (this effectively means that your total income before any reliefs could be higher than the £50,270) and these are namely:

  • Donations under Gift Aid.
  • Personal pension contributions.
  • Investments under Venture Capital Trust schemes (EIS, SEIS and SITR).

If you earn £60,000 and have combined tax reliefs of £10,000 your taxable income will be £50,000. As a result, your total income would be in the BR tax band. Therefore, in this example, you could take £60,000 as income and still be in basic rate tax.

To sum up, when you run your own business, you can take your earnings as a combination of salary and dividends. This blend of income is the current most tax effective way to pay yourself. When you are employed, you do not have this option.

Suggestion 

When considering the above and as part of this, maximising your take-home pay you could be:

  • Pay yourself a salary of £9,880 per annum -please note this is enough to count as a qualifying year for UK state pension purposes. The £9,880 equates to £823 per month and the director / employee will be required to pay a token amount of employees’ National Insurance contributions (NIC) while the employer will pay a small amount of employer’s NIC. However, please note, in 2022/23, it will be more tax effective to take a salary of £11,908 per annum (£992.33 per month) if you do not have any other income such as rental profits, self-employment profits, pension income etc that will use up your personal allowance. This is because the point where NI becomes payable is being aligned with the point where income tax becomes payable in July 2022.
  • Your company makes dividend payments of £38,280 over the course of the tax year if you take a salary of £992.33 per month. In turn, this equates to a monthly dividend of £3,190. Alternatively, your company makes dividend payments of £40,296 over the course of the year if you take a salary of £823 per month. This equates to a monthly dividend of £3,358.

Result

As a result, if you add together the annual salary and the annual dividend, this would give total earnings just under £50,270. This combination is the most tax-efficient mix if you have your own business, and your total income is just under £50,270.

Tax allowances 

When looking at how to maximise your tax allowances, the personal tax allowances that are available to you in 2022/23 are as follows:

  • Your tax-free personal allowance is £12,570.
  • Your tax-free dividend allowance is £2,000.

There is also an option to claim part of your married couple allowance if you are married or in a civil partnership. This is not available for everyone and is only beneficial if one partner earns under the higher rates tax bracket (£50,270 pa) and the other partner does not use up their personal tax allowance (£12,570 pa).

Working out the tax and take-home pay 

When you pay yourself tax efficiently and maximise your basic rate tax band, in working out which tax bands cover which types of income, you need to note:

  • Your personal allowance covers the £9,880 or £11,908 salary that we show above.
  • First, you need to take your personal allowance of £12,570. Next, deduct from this the £9,880 or £11,908 above. The result is £2,690 or £662 and therefore this amount of your dividends are also covered by your personal allowance.
  • Finally, take the dividend figure above of £38,280 or £40,296 and deduct the £662 or £2,690 and £2,000 above and this leaves £35,618 or £35,606. If you multiply this by the BR rate of tax on dividends (8.75%), it gives £3,116 or £3,115.
  • In conclusion, the tax-efficient result is the tax you pay, as personal tax, is £3,116 or £3,115 and you will pay this via your Self-Assessment tax return at a later date.

Monthly earnings and tax savings

When you look at being tax efficient, as shown in the scenario above, this will result in:

  • First, you can take a monthly salary from the company bank account of £823 or £992.33.
  • Second, your monthly dividend to pay from the company account is £3,358 or £3,190.
  • You will need to save £3,115 or £3,116 divided into 12 = £259.67 per month to cover your personal tax that you will need to pay later on. Personal tax is payable to HM Revenue & Customs via your Self-Assessment Tax Return.
  • In short, £823 or £992.33 plus £3,358 or £3,190 minus £259.67 = £3,921.33 or £3,922.636 net earnings each month -you have maximised your BR tax band.
  • To sum up, this will leave the director’s gross income just under the BR rate tax band of £50,270 pa.

Other considerations

Income from other sources

Please note, when you consider the most tax efficient way to take money out of a company, you might have other income. Such income could include rental profits, bank interest, or other dividends. Therefore, any other income would need taking into account, when working out how to pay yourself tax efficiently through your own company.

Higher rates tax

You can maximise your basic rate tax band as described above, however, if you as an individual, personally earn more than £50,270 in 2022/23:

  • Dividends that fall in the higher rates tax band, i.e., above £50,270, are taxable at 33.75%.
  • If you earn above £100,000 as your personal taxable income, you start to lose your personal allowance the more that you earn. You will effectively lose £1 or your personal allowance for each tax-adjusted £2 of income that you make above this.
  • When you earn more than £150,000, you will pay tax at the additional rate tax band which is 39.35% on dividends.

Final thoughts 

The article above shows the position quite well for 2022/23, in terms of how to maximise your basic rate tax band. It also explains at the same time how to show tax efficiency. However, you would indeed need to do further workings if you have any other sizeable sources of other income.

There could also be further things to consider if you live in Scotland, and are subject to the Scottish tax bands.

Going forward, we will continue to update this article in the future. This will take place when the UK tax allowances, tax bands and rates change.

Furthermore, besides showing how you can pay yourself tax efficiently, there are many other good reads on this website. These cover how salary, dividends, expenses, profit and many other areas work. They also include many ways of how you can be tax-efficient and save tax as you go along, and what to watch out for when running your own business.

As a final aside, if you have worked at several different employers in the past and have various pension schemes, something that you may be interested in is pension consolidation.

Link to Contractor Advice UK group on

LinkedIn    https://www.linkedin.com/groups/4660081/

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