Everyone is familiar with the famous Benjamin Franklin phrase that nothing is certain except death and taxes, and it’s true to say that taxes are a necessity.
Taxation is an essential component of any economy and the taxes we pay fund public services such as schools, prisons, the NHS, defence and more. They also cover social security programmes such as the state pension and universal credit.
You can be taxed on various income streams, both as an individual or through your business, including income tax, dividend tax, VAT, corporation tax, capital gains tax, inheritance tax and stamp duty.
Not all taxes are the same, however, and rates vary depending on factors such as the type of tax being levied and your total income. Having an understanding of the different tax rates is crucial to be able to make informed financial decisions. This is especially the case when you work through your own limited company regarding how you structure your income to improve your tax-efficiency and maximise your retained earnings.
Read on as we take a dive into the nuances of dividend tax rates and how paying yourself through a combination of salary and dividends can positively impact your income.
What are Dividends?
Dividends are paid by limited companies to shareholders out of company profits after corporation tax. Dividends are a flexible way to remunerate yourself.
Company shareholders can choose when they receive them. Generally, they’re paid regularly, such as quarterly, but could also be paid annually. They also offer remuneration flexibility from a tax-efficiency perspective.
Dividend tax is levied on this income and the dividend tax rates are dependent on the amount of dividends you receive, total income and which tax band you fall into. If you receive more than £10,000 in dividend income you’ll need to complete a Self-Assessment Tax Return.
Income and Dividend Tax Rates
Dividend tax rates are lower than income tax rates which presents an opportunity to improve tax-efficiency. To determine the best remuneration structure, an understanding of the various allowances, tax bands, income tax rates and dividend tax rates is needed.
Dividend Allowance
The first £1,000 of dividend income that you receive is tax-free. This is your dividend allowance and is applicable regardless of your total income. This amount was £2,000 for five consecutive tax years but was halved for the 2023/24 tax year effective from 6th April 2023.
This allowance is also expected to reduce to £500 for the upcoming 2024/25 tax year.
Personal Allowance
Thanks to the personal allowance, any income from salary up to £12,570 is untaxed. If, however, you earn over £100,000 your personal allowance is reduced by £1 for every £2 net that you earn above £100,000.
Basic Rate Taxpayers
If your total income is between £12,571 and £50,270 you fall into the basic rate tax band. Any dividends you receive over the dividend allowance are taxed at 8.75% and any salary you receive over the personal allowance is taxed at 20%.
Higher Rate Taxpayers
With a total income between £50,271 and £125,140 you’re a higher rate taxpayer. In this tax band, dividend income is taxed at 33.75% and salary is taxed at 40% above your allowances.
Additional Rate Taxpayers
As an additional rate taxpayer with a total income over £125,140, you’ll pay 39.35% tax on dividend income and 45% tax on salary but you don’t receive a personal allowance with an income over this amount.
How Do Dividends Work In Practice?
Let’s use an example of a contractor working through their own limited company that receives an annual income of £50,000 and assess the impact of different remuneration strategies.
Salary Only
If the contractor pays themself through salary only, they will be taxed at 20% on their income over the personal allowance. This means that £37,430 income is taxable at the basic rate of 20% giving an income of £42,514 net of income tax.
Salary and Dividends
Now let’s say the contractor decides to switch up their remuneration strategy and pay themselves the same amount through a combination of salary and dividends. The most tax-efficient salary is at the personal allowance threshold of £12,570, and the first £1,000 of dividends is untaxed thanks to the dividend allowance, which means £13,570 of untaxed income.
The remaining £36,430 is then paid through dividends which are taxed at the basic rate band dividend tax rate of 8.75%. That gives a net dividend income of £34,242.38 including the dividend allowance, and a net income of £46,812.38 including salary.
That’s an increase in take home pay of £4,298.38 per year from simply restructuring how they pay themselves.
If their earnings increased slightly so they moved into the lower end of the higher rate tax band, because of the higher tax rates levied in that band net income would actually be lower. Careful planning is therefore required.
It’s also important to note that personal and dividend allowances, tax bands and income and dividend tax rates can all change. You should therefore always keep abreast of any changes to ensure you’re operating as tax-efficiently as possible.
We understand that isn’t easy, especially for busy contractors. This is why as part of our accounting service we offer unlimited support and advice from your own dedicated accountant, including how to optimise your tax position and maximise your take home pay. With a same day response guaranteed and full FreeAgent access included, we will take care of all your business and personal accounting needs and ensure you’re operating as tax-efficiently as possible.
If you’re a sole trader and would like to incorporate your business and optimise your remuneration, our company formation service will get your limited company up and running in no time.
You can use our Salary & Dividend Tax Calculator to quickly and easily assess how different income scenarios can impact your tax liability and take home pay.
Call 0330 024 0406 to speak to an accountant if you have any queries about dividend tax rates or our service, or request a call back here.
