If you have control over the salary and dividends you receive from your company, this time of year is important for tax and NI planning. Especially this year if profits have been adversely affected by the pandemic. What factors should you consider for maximum tax efficiency?
As a general rule, for director shareholders a small salary topped up by dividends out of company profits is the way to go for maximum tax efficiency. Your salary should be pitched below the level at which NI contributions begin, but at least equal to the NI lower earnings limit (LEL). This is a key target figure for tax efficiency even if your company’s profits have been hit by the pandemic.
Salary, NI and state benefits
When considering how much salary to take there are two limits to watch. The first is the LEL. Up to that point neither you nor your company pay NI, but you get the NI credits that count towards your state pension and other benefits. The second is the primary earnings threshold (PET), which is the point at which you start paying NI. In between these two limits is the secondary earnings threshold (SET) which is the starting point for your company to pay NI.
If you only have one source of earnings, or you aren’t paying NI on other earnings you have, the optimum level of salary to take from your company is between the LEL – which for 2021/22 (and 2020/21) is £6,240 – and the PET – which is £9,568 for 2021/22 (£9,504 for 2020/21). If you haven’t paid yourself a salary in 2020/21, or it’s less than the SET, you have until midnight on 5 April 2021 to do so to ensure you get NI credits for the whole year.
If your company’s profits have fallen or it’s registered a loss you need to take care when deciding whether and how much to pay in dividends. You need to consider both the tax year and your company’s financial year. Remember that your company can only declare and pay you dividends if it has accumulated profits. This means if it has little or no profits, whether to pay dividends or not to maximise tax efficiency is academic as your company must have enough profits to cover the dividend you want to pay. If its income has fallen off there are increased tax and other risks to paying dividends.
If dividends are paid in excess of your company’s profits, the excess is unlawful, and you and the other shareholder’s may have to repay some or all of what was received. Until they are repaid HMRC will treat the excess dividends as a loan to the director shareholders which potentially triggers a corporation tax charge.
If your company has sufficient accumulated profits to more than cover any losses in the current year, you can think about how much dividend to pay in addition to your salary in order to achieve maximum tax efficiency . This can be a tricky balancing act if there are two or more director shareholders whose taxable income differs significantly. Notwithstanding that, the target is to pay a dividend that brings your total taxable income for 2020/21 up to the basic rate threshold of £50,000. Up to this level you’ll only pay 7.5% tax on dividends. At this stage it’s too early to worry about dividend levels for 2021/22.
Generally, for 2020/21 set a salary at least equal to the NI lower limit of £6,240 but no more than the primary earnings threshold of £9,504. You have until 5 April to bring your salary up to this level. When considering salary, dividends and other income together, £50,000 is the most tax efficient.