IT Contractor Tax - Accountants for Contractors

One of the most important rules that limited company contractors should always adhere to is to only draw down dividends when there are sufficient profits in the company accounts to cover them.

You must always ensure that your accounts balance, and that you can settle all your company tax liabilities when they are due - Corporation Tax and Value Added Tax (VAT).

So, once your corporate liabilities have been accounted for, how much should you put aside from your personal drawings for income tax?

Unless you are caught by IR35, in which case you will be taxed as a 'deemed employee' subject to normal PAYE and National Insurance rules, it is fairly easy to work out how much tax you should set aside.

Most limited company contractors pay themselves a small salary, and the remainder of their income comes in the form of dividends.

Dividend tax rates

There are three rates of dividend tax (for the 2011/12 tax year):

10% (basic rate)
32.5% (higher rate) - on income over £35,000
42.5% (additional rate) - on income over £150,000

Effective tax rates

Before working out your dividend tax liability, a 10% tax credit is added to the net dividend amount (to take into account the corporation tax already paid by the company on income).

For example, if your company pays a net dividend of £1,000, this actually represents taxable income of £1,111.

When applied to a net dividend, the 10% tax credit effectively wipes out the 10% basic rate of tax on dividends, so there is no further tax to pay.

From the higher rate income tax threshold onwards, the effective dividend tax liability is 25%.

The effective dividend tax rate on earnings above the additional rate threshold for £150k+ earners is a staggering 36.11%.

Personal allowance erosion

From 6th April 2010, the value of the personal allowance has also been eroded by £1 for every £2 you earn over £100,000 up to the £112,950 mark (in 2010/11) and up to £114,950 (in 2011/12). So, above these income limits, you have no tax free allowance at all.

For all calculations, you should use the gross dividend amount to work out your taxable income (i.e. your net dividend + the 10% tax credit, as discussed above).

Conclusion

As a simple estimate of how much income tax you can expect to pay, contractors should put aside around 25% of their income after they enter the higher rate tax bracket (£35,000 in the 2011-12 tax year). The threshold will drop further to £34,370 for the 2012/13 tax year.

Contractors penalised by the additional rate of tax should put around 36% of their income beyond £150,000 aside for tax.

This is just an approximate guide to calculating your potential tax liabilities. If you have any questions relation to taxation, your first port of call should always be your accountant, who should be able to tell you how much money you can declare as dividends at any one time.

Alternatively, if you use accounting software on an ongoing basis, you should be able to work out fairly easily what dividend amounts can legally be declared by your company.

You can find out more in our guide to dividend taxation.