Starting a limited company is often a sensible choice for self-employed workers, but it can present you with a lot of things to get your head around.
One of the differences between being paid by an employer and running your own business is having to sort out how your limited company pays you. Usually, the most tax-efficient way you can do this is by taking a combination of salary and dividends from your limited company. The salary will be paid to you as a director, in the same way as a regular employee.
You’ll need to make sure that you meet all your reporting and tax filing responsibilities for running your payroll under HMRC’s Real-Time Information (RTI) rules or you may incur fines and penalties.
If you’re a sole trader then the situation is different, you should read our article “How to pay yourself as a sole trader’.
Why take a salary?
There are two main reasons to take a salary from your limited company:
High or low salary – why would I want to take a low salary?
Under HMRC’s rules, ‘office holders’ (ie. people who hold a position at a company but don’t have a contract, or receive regular salary payments) aren’t subject to the National Minimum Wage Regulations unless there‘s a contract of employment in place.
A low salary can be paid which means you do not have to pay Income Tax or National Insurance Contributions (NICs) on that salary.
As a UK taxpayer, each year you’ll have a Personal Allowance – any income you receive up to the Personal Allowance is free from Income Tax. In the 2019/20 and 2020/21 tax years this threshold is £12,500.
There are also National Insurance (NI) thresholds to be aware of. They’re all currently lower than the Personal Allowance and are important when setting your salary:
- The Lower Earnings Limit – as long as your salary is set above this level, you’ll retain your State Pension contribution record
- The National Insurance (NI) Primary threshold – as long as your salary is below this level, you won’t need to pay any employee’s NICs
- The National Insurance (NI) Secondary threshold – as long as your salary is below this level, your limited company won’t need to pay any employer’s NICs
So, the aim is to set your salary at a level that is above the Lower Earnings Limit to obtain the benefits of qualifying for the state pension, but below the level where you’ll need to pay either employee or employer’s NI. Win, win!
So what are the National Insurance thresholds and how do they affect a director’s salary?
For the 2019/20 tax year, if your salary is above the National Insurance (NI) ‘Lower Earnings Limit’ (£6,136) but below the NI ‘Primary Threshold’ (£8,632), you don’t pay employee’s NICs, but you do retain your State Pension contribution record.
The situation has changed in the 2020/21 tax year as the government has announced that the Primary threshold for NI will increase to £9,500 from 6th April 2020.
The change means that for the 2020/21 tax year the NI Primary threshold will be higher than the NI Secondary threshold. The Secondary threshold is £169 per week or £8,788 per annum from 6th April 2020.
One important impact of this change is that, for the 2020/21 tax year, we’ve calculated that setting your salary at the NI Primary threshold would mean your company will need to pay Employer’s NI and your company’s profits will be reduced due to the increased salary costs. Any reduction in your company’s profits reduces the amount of dividends available to distribute to your company’s shareholders.
This means that the most tax-efficient salary for a limited company director with no other sources of taxable income for the 2020/21 tax year will usually be £732.33 per month (£8,788 for the 2020/21 tax year) which is the NI Secondary threshold amount.
High or low salary – why might I want to take a higher salary?
If your salary is set at a very low level, or if you don’t take a salary at all, there are disadvantages, such as:
- Reduced maternity benefits. Technically, to qualify for maternity benefits, you need to be “employed” and thus be compliant with the National Minimum Wage Regulations
- You could miss out on part of your annual tax-free personal allowance if your salary is paid at the NIC threshold and you have no other sources of income. (You should ensure that you understand the impact of the total amount of salary and dividends you take from your company and other sources of income on your available tax-free personal allowance)
- Reduced cover under permanent health, critical illness, personal accident or similar policies, where payouts are calculated based on your earnings
- Issues with National Minimum Wage Regulations if you want to have a Contract of Employment
- When applying for a loan or a mortgage you may need to meet certain criteria which are unsympathetic to a low salary. However, there can be ways around this if you use a specialist self-employed mortgage broker such as Crunch Mortgages team can advise you on the best way to qualify for a self-employed mortgage).
Paying yourself in dividends
If your company makes a profit, which it hopefully will, then you have two options available to you. You can either reinvest your profit into the company or take it out and pay shareholders by issuing a dividend.
The term “shareholder” simply refers to the owner(s) of the company. So, if you own and manage your limited company, you can pay yourself a dividend. This can be a tax-efficient way to take money out of your company, due to the lower personal tax paid on dividends.
Through combining dividend payments with a salary, you can ensure that you’re at optimum tax efficiency. You can find out more about dividends in our “What are dividends and what taxes do I pay on them?” article.
Tax implications of taking a salary
As with regular full-time employees, all salaries will be subject to tax via Pay-as-you-earn (PAYE). With three separate PAYE ‘taxes’, the benefit of reducing your Corporation Tax liability by taking a higher salary can soon be outweighed by the additional tax paid.
Income tax is cumulative on all employment earnings and other sources of income in a tax year. For example, if you’ve already earned £10,000 from any employment in a given tax year, your tax-free Personal Allowance will be reduced by this amount.
You can check out our tax rates and thresholds article for more information on the Income Tax rates.
Employee National Insurance Contributions
Unlike Income Tax, employee National Insurance Contributions (NICs) aren’t cumulative. This means each new employment has a separate earnings threshold before NICs are due. For employees who are Higher Rate taxpayers, there’s a maximum limit on the amount of NICs to be paid.
If you’re an employee (but not a director), this threshold is set as a monthly amount. If you’re paid over this amount in any given month, you’ll have to pay NICs even if your pay for the rest of the year is reduced.
Directors have an annual threshold, which is 52 times the weekly threshold amount. When salary starts to go over this, they pay NICs.
We’ve got an article with all the tax and National Insurance thresholds and rates.
Employer National Insurance Contributions
The threshold for employer NICs works in the same way as employees. For every salary amount your employee earns above the weekly National Insurance earnings threshold, the employer has to pay NICs at 13.8%. This also applies to your own director’s salary and represents another PAYE tax the company has to pay.
Read more about current tax rates and thresholds
Putting it all together
Taking all the above taxes together, in the 2019/20 tax year, it’s usually tax-efficient for most limited company directors to take a salary up to the Primary National Insurance threshold – £8,632 in the 2019/20 tax year.
In the 2020/21 tax year, however, the salary amount should usually be set at the NI Secondary threshold which is £732.33 per month – £8,788 for the 2020/21 tax year.
As we mentioned at the start of this article, as the Lower Earnings Limit is below the point at which you pay employee or employer’s NICs, you’ll still accrue qualifying years for the state pension.
If you pay yourself a salary up to the relevant National Insurance threshold from your limited company, you won’t pay any Income Tax or National Insurance on it as long as it’s your only earnings. We usually recommend this option on the basis of tax efficiency. There may be reasons, as outlined above, why you may decide to pay yourself a higher salary.
As a company director, you can choose the amount of salary you’re paid, but you may wish to get advice from one of our expert accountants to ensure you’re paying yourself in the most tax-efficient way.
If you’re a Crunch client and wish to pay yourself a salary higher than the relevant National Insurance threshold amount, please contact your client managers as you may need to take up our additional payroll service or upgrade to our Plus package.