Working out the most tax-efficient way to draw down income from your company should be a priority for limited company directors. In this article, we explain how to work out the optimum salary level for the 2020/21 tax year.
Limited company directors
If you are a limited company director, you have a lot of flexibility over how and when you pay yourself and any co-directors.
Although the tax difference between company directors and traditional employees has reduced in recent years, one remaining tax benefit of incorporating is that dividends are not subject to National Insurance Contributions, whereas salaries are.
What is the optimum salary level for directors for 2020/21?
It is worthwhile drawing a salary from your company, as this cost is deductible against the company’s Corporation Tax bill.
However, the tax benefits of drawing a salary diminish as you pass through the prevailing income tax and NIC thresholds.
Here are some general factors to consider when working out your optimum salary level (and that of your spouse / other employees, if applicable):
a) £8,788 salary (tax-efficient, no NI admin)
- If you are entitled to the full personal allowance, you will not pay any income tax at all if your salary level doesn’t cross this threshold. For 2020/21, the standard personal allowance is £12,500 (same as the previous year).
- For the 2020/21 tax year, your company only starts paying Employers’ National Insurance Contributions when your annual salary reaches £8,788. Employees’ NICs are also payable, but only when your salary reaches the £9,500 mark.
- As a result, if your company is not claiming the Employment Allowance (see below), £8,788 is a tax-efficient salary to draw this year, with no National Insurance admin involved.
- Make sure you take into account any other income you have already received in the current tax year (for example, if you received a salary from a previous job or have rental or savings income).
- There is no legal requirement to pay yourself the National Minimum Wage unless you have a contract of employment with your own company which states otherwise (this is very unusual).
- This salary level is above the Lower Earnings Limit for National Insurance required in order to qualify for state benefits (for 2020/21, this is £120 per week / £6,240 per year).
b) £9,500 salary (slightly more tax-efficient, some NI admin)
- Carrying on from the previous points, there is a small tax advantage to taking a £9,500 salary compared to £8,788, although you will need to account for National Insurance paperwork.
- No Employees’ NICs or income tax is payable at this salary level.
- However, Employers’ NICs at 13.8 % is payable on the additional salary (£9,500 – £8,788 = £712). £712 x 0.138 = £98.26.
- Your company won’t have to pay Corporation Tax @ 19% on this additional salary, or the extra Employers’ NIC costs. So, the company is saving 0.19 x (£712 + £98.26) = £153.95
- This gives an overall small saving to your company of £55.69 per year compared to £8,788.
- There may be some admin costs associated with accounting for Employers’ NICs at this salary level; it depends on your own circumstances. Some contractors may prefer to draw down £8,788 per year and have no NI concerns, whereas others won’t have any additional costs, as NI is dealt with by their accountants for no extra charge.
c) £12,500 salary (most tax-efficient, if you can claim the Employment Allowance)
If you are not caught by IR35, and not the sole director/employee of your company earning over the Secondary Threshold, it may be tax-efficient to pay yourself a higher salary than £8,788 and claim the Employment Allowance (EA):
- The EA, which was first introduced in April 2014, will refund any Employers’ NICs your company pays, up to a maximum of £4,000. You must check with your accountant to see if your company is eligible (as most contractor companies are not).
- You will still have to pay Employees’ NICs on any salary of over £9,500.
- So, if your company pays you £12,500 during the current tax year, you will pay no income tax at all, the salary is deductible against your company’s Corporation Tax bill, and you’ll pay £360 in Employees’ NICs.
- The £512.26 Employers’ NICs will be refunded via the Employment Allowance (EA) scheme. However, you cannot claim the EA if you are the sole director of your company, and have no other employees.
- Your company will also save £705.28 in Corporation Tax if you decide to take a £12,500 salary instead of £8,788.
- You will be around £345 better off per year as a result of the corporate and personal tax savings compared to the £8,788 salary level.
- So, overall, you are better off paying yourself a £12,500 salary during 2020/21, if your company is eligible to claim the EA.
- You can find out more about the EA and see a calculation here.
Umbrella company employees
If you are a PAYE umbrella company employee, your income will be subject to standard PAYE (Pay-As-You-Earn) income tax deductions and National Insurance Contributions.
Although there may be differences in service charges, and the value of ‘perks’ offered by different umbrella scheme operators, you should be subject to exactly the same levels of taxation. It is unethical for umbrella firms to claim otherwise.
What about dividends?
After you have decided upon the right salary level to pay yourself (and any employees) during the tax year, any remaining profits can be distributed to the company’s shareholders in the form of dividends, which are taxed as follows:
- 7.5% (basic rate)
- 32.5% (higher rate)
- 38.1% (additional rate)
There is also a £2,000 dividend allowance which sits within your existing tax bands.
Dividends are taxed as the ‘top slice’ of income, so after you have taken into account your salary, and any other earnings and investment income. Find out more in our guide to dividend tax.
- Get email updates on any future limited company tax changes, via our newsletter.
- Find out more about what dividends are, and how to account for them in our detailed guide to limited company dividends.
- If you are starting out as a contractor, try our directory of accountants for some initial suggestions.
- Although the information contained on our site is verified by our own accountant, this article should be used as a guide only. Please contact your own accountant if you have any questions.
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