Once you’ve set up an incorporated business and become a director, you have to be smart about how you extract profit to avoid paying more tax than you need to.
There are three main routes for a director to extract profits from their own limited company – salary, dividends and pension contributions. Usually, combining these three methods is the most tax-efficient approach to minimise your tax bill.
With corporation tax applying (at 19% in 2022/23) on any of your company’s taxable profits from its accounting period, the money you take out of the profits to pay yourself can potentially reduce your company’s corporation tax liability.
Pay yourself a small salary
When running a limited company, it might be easy to overlook that your business’s money doesn’t go straight into your personal bank account.
So, to get it into your pockets, consider paying yourself a basic salary. This is often set just below certain thresholds for National Insurance contributions (NICs). If, for example, you pay yourself more than the lower-earning limit (£6,396 in 2022/23), you will accrue qualifying years towards your state pension.
However, your company will become liable for employers’ NICs at a rate of 13.8% on any earnings above £9.100. If you pay yourself a penny less than £9,100 in 2022/23, your company avoids paying this NIC altogether.
The next payroll consideration is the personal allowance (£12,570 in 2022/23). The basic rate of income tax doesn’t apply until you exceed this threshold.
One other pertinent point to consider is that any salary you pay yourself will be treated as a business expense, which means it will reduce your taxable profit and lower the amount of corporation tax your company pays.
Taking dividends
Dividends are paid to an incorporated company’s shareholders from post corporation tax profits. Usually, a director will be one of those shareholders and quite often the sole shareholder.
Many directors pay themselves in a combination of salary and dividends. As dividends are drawn from profit, you need to show you have profit reserves available before issuing dividends.
Dividends are a different form of taxable income, and they are treated slightly differently in comparison to salary. The same income tax bands apply, but different dividend tax rates are associated with them.
The best way to illustrate how dividends are taxed is through an example. Let’s say you’re the sole shareholder, your company has made post-tax profits of £29,570, and your accounting period runs parallel to the tax year.
You take £8,000 as salary in 2022/23 and £29,570 in dividends, £37,570 in total. The £2,000 dividend allowance makes £27,570 of your dividend taxable.
Once the personal allowance of £12,570 is deducted from your salary and dividend income, £23,000 of your dividends will be taxable at 8.75% as you will fall into the basic-rate income tax band. This would leave you with a tax bill of £2,012.50.
Pension contributions
The single most tax-efficient way to extract profits from your company, but not the most practical, is to make employer contributions towards your pension pot.
Pension contributions reduce the company’s liability to corporation tax and they are not subject to NICs.
You can potentially put up to £40,000 gross into your pension pot over the course of the tax year. If you haven’t used any of your annual pension allowance over the last three tax years, you might be able to carry over any unused annual allowance from those years.
The total amount you can save without incurring charges into your pension pot is currently capped at £1,073,100, due to what’s known as the ‘lifetime limit’.
Assuming you stay under these thresholds, when the time comes to take your pension benefits – currently after the age of 55 but rising to 57 from April 2028 – 25% is normally tax-free.
The rest of your retirement income that exceeds the personal allowance will be taxed at your marginal rate of income tax under the existing rules.
Whichever way you go about extracting profits from your incorporated business, getting personal tax planning advice will always help you pay the least amount of tax legally possible.
If you need help with anything discussed in this article, our specialist tax advisors are here to help. Contact Fiona Mitchell at fmitchell@thomsoncooper.com or call 01383 628800.