Our second Questions on Wednesday, again with a few quickfire questions I’ve had over the week. With the tax season out of the way, attention moves towards the 5th of April. With just over two months until the end of the tax year, it is a chance for individuals to make the most out of their allowances with some final planning. This week, I talk about the “60%” tax bracket, the ideal director’s salary and dividends. All the below is based on rates from the 2020/2021 tax year.
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What is the 60% tax bracket?
Most of us are aware of the three tax brackets in England. After you’ve used your £12,500 allowance, you pay basic rate at 20%. From £50,001 you pay the higher rate of 40%. Then, from £150,001 the additional rate of 45% kicks in.
But did you know there is an effective 60% tax amongst this? It’s a little tricky to explain.
From £100,000, for every £2 you earn, you will lose £1 of your personal allowance. This happens up to £125,000, at which point your allowance is completely gone.
The reason it is effectively 60% is because the threshold for that higher rate of tax begins to fall from £50,000 to £37,500. So, every £1 lost of your allowance means another £1 is being brought into that 40% bracket. You lose £1 of allowance for every £2 earned remember, so you need to halve that 40%, making the effective tax 20%. You add this to the 40% tax bracket you’re in already and that’s the 60%. Still not sure? See the example below.
Joe Bloggs is earning £100,000. He’s in the higher rate bracket of tax and his tax is £27,500.
Joe then gets a bonus on top of £10,000. Two things happen here.
First, he’s taxed 40% on that £10,000. That’s £4,000.
Then, he’s lost half of that from his personal allowance. That’s £5,000 now taxed at 40%, being £2,000.
So, for a £10,000 bonus, he’s effectively had to pay £6,000 or 60% effective tax!!
This means for those individuals who are close to or within this £100,000 – £125,000 range should be thinking very carefully about what they can do now to keep out this bracket. The good news is there are some options to hand.
Keeping out the 60% bracket
First, a great option is to top up your pension pot, bringing your tax bill down and topping up your retirement savings. Seek proper advice from a financial advisor before doing this of course.
Also, why not consider making donations to charity? Aside from doing good, you’re also saving a heap of tax. Do make sure it’s a qualifying Gift Aid charity though.
Your employer may also have salary sacrifice options that could trade taxable for non-taxable benefits too.
If your income is from your own business or ventures, then your accountant may have some extra options to explore.
By the way, Wales and Scotland can set their own tax rates. Wales are the same as England for now, but in Scotland the rates are a little more complex.
What’s the ideal salary for a director?
There is still time for directors of owner-managed businesses to get a payroll across and make the most of a basic allowance if they haven’t already. But what should you pay yourself?
This probably could form another blog in its own right, but let’s cover the basics. We’ll assume a standard category A payer here.
- From £520 a month, you enter the nil-rate band for National Insurance (NI). This figure is important. Pay yourself at least this a month and you’ll be contributing towards your qualifying years for a state pension. Very important.
- But you can go further. This nil-rate band goes up to £732 a month. This is known as the Secondary Threshold (ST). After this, your company must pay towards NI at 13.8%.
- At £792, employees now pay NI at 12%, having reached the Primary Threshold (PT).
- Finally, at £1,041.67, you begin paying income tax.
So, what is best?
If you are the only individual being paid from your business, £732 a month is the highest you can go without paying tax. Even beyond this, you pay 13.8% on each £1 over, but can also get corporation tax relief on that employer’s NI.
With two or more employees or directors paid a salary of this size, you can make the most of the Employment Allowance. This is a £4,000 allowance on employer’s national insurance, meaning you can push towards the Secondary Threshold rate of £792 per month without paying tax.
There could be cases for increasing your salary, or not taking a salary at all. And you cannot ignore corporation tax relief, any other income you might have and other factors that could change what’s best for you.
Should I pay myself a dividend?
Dividends are taxed slightly different from salary. Whilst you also go through the same income bands as above, the rates differ.
Basic rate dividends are 7.5%, higher rate 32.5% and additional rate 38.1%.
Sure, those rates are better than above (and without national insurance to pay), but you can only pay a dividend from taxed profits – taxed at 19% corporation tax. I touched briefly on this and dividends as the bulk of your income from a limited company can make sense. It’s generally more tax efficient than being a sole trader or having it all as PAYE.
The one big distinction from dividends though is you get an extra £2,000 dividend allowance, tax free. Regardless of your income, this is another £2,000 you can take without paying tax.
So, if you have profits in the business and your circumstances are right, take the £2,000 out as a dividend, as it’s an incredibly tax efficient way to get cash out of the business.
It’s worth noting though this still does contribute to your total income, so if you’re on the £100,000 mark with another venture, the dividend may tip you over the edge and be less worthwhile, so do check your situation carefully.
Worried about an impending tax bill? Run a limited company and need help with your payroll? Not clear on your dividend strategy? Get in touch today to see how we can help.