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

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Introduction -the most tax-efficient way to pay yourself   

As a contractor, when we think about how to be tax-efficient (UK), what should we consider? In addition, when you run your own business what is the most tax-efficient way to pay yourself? This is a common thought for many business owners and is key to consider tax-efficiency when it comes to your take-home pay. The income tax rate for contractors will vary depending on the individual’s level of taxable income. When you are a UK contractor, if you can achieve the most tax-efficient mix of dividends and salary, it will ensure your overall contractor’s tax rate is no higher than it needs to be.

When you run your own UK company, you need to consider how do you pay yourself as a business owner (UK). Therefore, it is good to think about what you can do to:

  • Make day-to-day savings and, as part of this, maximise your company profit.
  • Maximise your own take-home pay as a company director and as a result you can pay yourself more.

Furthermore, when you are a limited company contractor what should we consider when we think about your contractor tax rate and tax-efficiency in the 2022/23 tax year?

Making savings personally and as a business

When you are looking to save money personally it is good to reduce your spending, and when you are running a business, it is good to reduce your tax bill:

  • As an individual, you could look to shop around in terms of what you buy. Secondly, you can put any of your savings into a stocks and shares ISA.
  • As a business owner and limited company director, you can look to make savings on what your company buys, and it can also look to make tax savings by claiming for all its valid business expenses. When you claim for all valid expenses, it helps to reduce the company tax liabilities. Another way to save tax through your company is to ensure that you pay yourself tax efficiently.

This article will examine how to extract profits and be tax-efficient when running your own business.

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

Initial thoughts -the most tax-efficient way to pay yourself as a director

Firstly, it seems that how to maximise your pay as a limited company contractor is not always very well understood. Therefore, we need to consider how to pay yourself as a contractor.

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 correct information to hand.

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

  • The best way to pay yourself tax efficiently via your UK limited company. This includes the tax-efficient ways to take money from a company.
  • How you can maximise your basic rate tax band. When you know this, you will be aware of how much can I earn before paying higher rate tax.
  • How to be more tax-efficient when you run your own UK business.

Financial year and tax year

The calendar year runs from 1 January to 31 December.

Your company’s financial year runs from the first day of your accounting period (or the date of your company’s incorporation if your company has just started) to the date of your company’s year-end. Therefore, if your company was incorporated on 15 July and your year-end in future will be 31 July:

  • The accounting period in year 1 will run from 15 July 2022 to 31 July 2023.
  • In year 2 it will run from 1 August 2023 to 31 July 2024.

The UK tax year runs from 6 April to 5 April. Therefore:

  • In the 22/23 tax year, it will run from 6 April 2022 to 5 April 2023.
  • In the 23/24 tax year, it will run from 6 April 2023 to 5 April 2024.

The most tax-efficient way to pay yourself as a contractor -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. It would help if you also claimed for these over each year, and they include:

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

Expenses help to lower your company’s profit. This results in a lower Corporation Tax bill and more post-tax profits. More profits results in more funds available to you as dividends.

Salary payments are business expenses and 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. When you have this choice, is it better to pay yourself a salary or dividends? Before we can 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 are the current tax bands and allowances?
  • How the above will interact with taxable income.
  • What are the current tax rates?
  • How the above is applied to different sources of income.

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

The most tax-efficient way to pay yourself as a director -recent tax changes in the UK 

Although we are looking at how to pay yourself tax-efficiently and maximise your basic rate tax band, let us 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, in 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.

Second example

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

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

A brief history of UK tax rates and bands 

First, the personal tax allowance and basic rate (BR) tax band usually change annually.

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

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

Most importantly, the standard personal allowance has been increasing over recent years. 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 that in recent tax years in the UK, there have been different allowances and tax rates in Scotland. Wales and Northern Ireland also have their tax allowances and tax rates, but these currently align with England.
  • Please also note that in recent times, the government brought in separate rates and tax bands for savings. These will indeed need to be taken into account if you have sizeable savings.

The most tax-efficient way to pay yourself -historical personal allowances & 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 that 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 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 adding this to the personal allowance gives a total of £50,270. This amount is the income limit before you start paying higher rates tax.

As shown above, the income tax rates for the basic rate band of 20% and higher rate band of 40% have been consistent over recent previous tax years. These are the income tax rates applied to earned income (salaries, self-employment profits etc.). The tax rates 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 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 as a contractor -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 that your company needs to be earning enough profit to be able to pay you the £50,270.

As mentioned, the maximum 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 £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 the take-home pay, you could:

  • 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). In contrast, 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 et. that will use up your personal allowance. This is because, from July 2022, the point where NI becomes payable is now aligned with the point where income tax becomes payable.
  • Your company makes dividend payments of £38,280 over 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 year if you take a salary of £823 per month. This equates to a monthly dividend of £3,358.

Result

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

The most tax-efficient way to pay yourself as a director -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 rate tax band (£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 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; therefore, this amount of your dividends is 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 later.

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 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 £3,922.66 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 around the most tax-efficient way to pay yourself 

Income from other sources 

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

Higher rate 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.

Director’s loans 

When you take money from your company, besides repaying expenses and net salaries, other withdrawals will usually be classed as dividends. If you need to draw more than what is shown in the example above, you could treat any excess as a payment to your director’s loan account. This will be a temporary loan to the director (you) however you need to ensure that you repay this in the future. When you have a director’s loan, there may also be two potential tax implications depending on how much you borrow and how long you borrow this for.

Final thoughts 

The article above shows the position quite nicely for 2022/23 regarding how to maximise your basic rate tax band. It also explains at the same time how to be tax-efficient (UK) as a contractor or limited company owner. However, you would indeed need to do further workings if you have any other sizeable sources of other income.

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

In the future, we will continue to update this article to show how you can show tax efficiency. This will occur when the UK tax allowances, tax bands and rates change.

And finally…

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 demonstrate how you can be tax-efficient and save tax as you go along and what to watch out for when running your business.

Finally, if you have worked at several different employers in the past and have various pension schemes, you may be interested in pension consolidation.

Link to Contractor Advice UK group on

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

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