Currently, assuming that your personal income from dividends does not take you into the higher rate income tax bracket (or above) in a tax year, then you will not pay any income tax on those dividends. This means that many Directors who are also shareholders are able to extract a tax efficient combination of salary and dividends totalling £39,206 without paying any income tax at all (based upon 2015/16 tax year).
What is changing?
From 6th April 2016, the current tax credit system whereby dividends are treated as being paid after a 10% tax credit has been applied is being replaced with a Dividend Allowance of £5,000. This means that the first £5,000 received in the form of dividends each year will not suffer income tax. However, once the Dividend Allowance has been exhausted, the remainder of the dividend(s) paid will be subject to income tax at the following rates:
- Basic Rate – 7.5%
- Higher Rate – 32.5%
- Additional Rate – 38.1%
As a result of the changes, a combination of salary (£11,000) and dividends (£5,000) totalling only £16,000 can be extracted without paying any income tax in the year ended 5th April 2017.
Unlike the income tax personal allowance, dividends extracted that are covered by the dividend allowance will form part of your taxable income band (i.e. such dividends will count as income when assessing how your overall income falls into the basic, higher and additional rate bands of income tax).
It should be noted, however, that the move away from the technical complication of ‘grossing up’ the net dividend payment in respect of the tax credit before calculating the income tax due is a welcome change.
Who will pay more tax as a result of the changes?
Unfortunately, most small business owners who operate through a Limited Company will pay more tax as a result of the changes to income tax on dividends (assuming they currently have the ‘standard’ mixture of tax efficient salary and dividends).
It should be noted, however, that dividends will continue to play a large part in the profit extraction decisions of company Directors. Do remember that dividends do not suffer employer or employee national insurance contributions. For this reason, along with the reduced rate of income tax compared to that suffered by employment income, dividends remain the profit extraction method of choice.
Will anyone benefit from the changes?
Yes. A small proportion of tax payers will benefit from the dividend changes. The main winners will be tax payers who have employment income that takes them into the higher rate or additional rate brackets of income tax, with additional dividend income of around £5,000 on top of the employment income. Currently, such individuals will pay income tax on their dividend income at an effective rate of 25% or higher after applying the 10% tax credit. From April, no income tax would be paid on the dividend income, assuming that it remains under £5,000. Therefore, such individuals will realise tax reductions of at least £1,250.
What can I do to remain tax efficient?
- Consider bringing forward dividends to 5th April 2016 or earlier (where company profit reserves allow) – to benefit from the existing tax credit dividend system.
- Consider having the company make contributions into your personal pension pot. These contributions will not form part of your taxable income (at least not until they are extracted in the future – depending on tax legislation at the point you withdraw your pension pot). The company will benefit with corporation tax relief on the contributions. No national insurance will be payable on the pension contributions by the company or you personally.
- Finally, don’t disregard dividends. It is true that more income tax will be paid. When compared to just extracting a large salary, however, dividends remain significantly more tax efficient.
How can e-ccountant help?
We are happy to look at forming a tax efficient profit extraction plan for all clients. If you would like help please do not hesitate to contact us today on 0203 3226630.