One of the most common questions asked by limited company contractors is what level of salary they should pay themselves as directors.
There are a number of things you need to consider when working out the most tax-efficient level to pay yourself, and any other employees.
How to decide what level of salary to take
We asked Richard Murray, head of operations at ClearSky Contractor Accounting, to provide an overview.
“As a company director, withdrawing a low salary topped up with dividends is the most tax-efficient way of taking money from your business – provided of course that you are operating outside IR35.
“For 2020-21, the tax-free personal allowance for most people stands at £12,500, but it is possible to draw a salary of as little as £8,788 and still qualify for the state pension. The most tax-efficient salary to draw will, therefore, depend on your circumstances (such as whether you have any other income) but will typically be between these two figures.
“You should also think very carefully about how much money you want to withdraw, especially if you need to demonstrate an income when applying for a loan or mortgage.
“Some lenders will include dividend income when establishing how much you can borrow, but this is not always the case. Therefore, it is always worth doing your research so you are able to make a well-informed decision.”
Considerations when working out the most tax-efficient salary
- Can your company claim the Employment Allowance? Whereby you can claim back any Employers’ NIC costs. Many small companies are excluded from this incentive.
- Have you already earned income from a previous role during the current tax year?
- Remember that the personal tax year runs from 6th April to the 5th April the following year.
- What are the current income tax thresholds? For example, the personal allowance is £12,500 this tax year, so you won’t pay any income tax on salary below this threshold.
- What are the current Employees’ and Employers’ National Insurance thresholds?
- Do you want to ensure you get a credit towards you State Pension entitlement? You will need to make sure your salary is higher than the NI Lower Earnings Limit (£6,240).
- Do you have a contract of employment with your company? It may state that you must pay directors and/or employees a minimum salary level.
- It is worth paying yourself a salary, as you save 19% Corporation Tax on this amount, which would otherwise be taxed as company profit.
- Find out what the most tax-efficient salary levels are for 2020/21 here.
Why can’t my accountant tell me what salary to choose?
If you ask your accountant for advice on setting the salary levels you pay to yourself (as a director), they will only be able to give you rough guidance – perhaps a variety of salary levels, and the comparison of the tax costs of each.
This is because accountants do not want to be at risk of being caught by the Managed Service Company (MSC) rules, which were put in place to outlaw service providers who do everything on behalf of limited company clients, including invoicing, making bank account transactions, and various other tasks which should be carried out independently by company owners.
So, what is the optimum director’s salary for 2020/21?
Broadly speaking, this is likely to be £8,788, £9,500 or £12,500, depending mainly on whether or not your company is eligible to claim the Employment Allowance or not. You can read our full breakdown of these salary levels here, and use our salary and dividends calculator to work out your tax liability for 2020/21.
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