Dividends vs salary: the new conundrum

This week’s guest blog comes from Stefano Del Federico of The Private Investment Office.

One of the biggest surprises from the emergency July 2015 summer budget was the change to the way in which dividends will be taxed from April 2016. Currently, all dividends came with a notional 10% tax credit. In essence, once a dividend payment is made, a tax deduction of 10% has already been taken at source. For basic rate taxpayers with no additional income, this means that the dividend paid has no further income tax liability.

However, from April 2016 all this changes. The 10% tax credit has been removed altogether and dividends receive their own annual personal allowance and three tax bands.

Dividends tax bands, 2016

From April 2016, the first £5,000 is free of tax. The remainder is taxed at the following rates:

Basic Rate 7.5%
Higher Rate 32.5%
Top/Additional Rate 38.1%

Previously, contractors and small business owners taking remuneration from their company via a dividend have enjoyed a dividend tax credit that removes the potential for double taxation, as a result of the tax their company already pays on its profits.

From April 2016, contractors who are basic rate taxpayers will pay 7.5% on their dividend income. Higher rate taxpayers will pay 32.5%, rising to 38.1% for top/additional rate taxpayers.

To incorporate or not to incorporate. That is the question

It is now even more important for sole traders and contractors to discuss their tax position with us, in order to decide if incorporating in order to save tax by taking a combination of dividends and a nominal salary, is still a viable option for them.

To give you an example of the impact of these changes, a company making a profit of £25,000 would be paying an additional £441 in tax. However, a company making a profit of £100,000, would pay an extra £2,752 from April 2016.

Tax-efficient retirement planning

Given these changes, it is all the more important to consider your level of drawings, your financial objectives and the overall tax consequences. For long-term savings and investments, a pension is still hard to beat. Personal pension contributions made by you or your business are eligible for tax relief (subject to certain limits) and following The Chancellor’s pension reforms, there are now many more ways to put these tax privileged funds to work. This can include paying down your mortgage, using the fund to buy a commercial property or contemplating your long term estate planning options.

However, you should be aware that the government is making the tax breaks less attractive for high earners. From April 2016, the maximum 40% tax relief normally available against pension contributions made from the next tax year onwards will be reduced considerably where income exceeds £150,000 per annum.

There is a window of opportunity to maximise this tax relief now, before the end of this tax year and before it’s too late.

Stefano Del Federico was writing for My Accountant Friend on behalf of The Private Investment Office, and is available to offer further advice. Customers of My Accountant Friend are also encouraged to get in touch sooner rather than later, in order to find out how these changes will affect them. 

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