Updated: Mar 20
There are two main reasons why as a director of a limited company you should pay yourself a salary.
The first, its counted as an allowable business expense, which means it lowers the amount of Corporation Tax. The second is that if that the salary is above the Lower Earnings Limit which is £6,240 in 2021/2022 tax year. You will accrue qualifying years towards your state pension.
So, you have decided to pay yourself a salary, but should that be a lower or higher salary? What are the advantages and disadvantages of both?
Under HMRC’s rules people who hold a position at a company but do not have a contract or receive regular salary payments, are not subject to the National Minimum Wage Regulations.
A low salary could be paid which means you do not have to pay Income Tax or National Insurance contributions on that salary. As a UK Taxpayer, each year you will have a personal allowance, which means any income you receive up to that personal allowance is free from income tax.
The threshold for the 2021/22 tax year is £12,750. There are also National Insurance thresholds that you should be aware of, which are currently lower than the personal allowance and are important when setting your salary.
So, with a low salary, the aim is to set your salary at a level that is above the Lower Earnings limit to obtain the benefits of qualifying for a state pension, but below the level that you need to pay either employee or employer’s NI. That is a Win, win in our book.
Why might you want to take a higher salary?
If your salary is at a low level, or if you do not 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 compliant with National Minimal 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.
· Reduced cover under permanent health, Critical illness, personal accident, or similar policies where pay-outs are calculated based on your earnings.
· When applying for a loan, or mortgage you may need to meet certain criteria which are unsympathetic to a low salary. However, there are ways around this if you use a specialist self-employed broker such as Crunch Mortgages. They can give you advice on the best way to qualify for a self-employed mortgage.
Tax implications of taking a salary.
As with regular 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 have already earned £10,000 from any employment in a given tax year, your tax-free personal allowance would be reduced by this amount.
Paying yourself in Dividends.
If your company takes 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, and you can pay yourself a dividend. This could be a tax efficient way to take money out of your own company, due to the lower personal tax paid on dividend, the rates for this year are 7.5% / 32.5% / 38.1%. Also with dividends you receive an allowance of £2000 per year at 0% tax rate.
Through combining dividends payments with a salary, you can make sure that you are at optimum tax efficiency.
Employee National Insurance Contributions
Unlike Income Tax, employee National Insurance Contributions (NICs) are not cumulative. This means each new employment has a separate earnings threshold before NICs are due. For employees who are Higher Rate taxpayers, there is a maximum limit on the amount of NICs to be paid.
If you are an employee (but not a director), this threshold is set as a monthly amount. If you are paid over this amount in any given month, you will 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.
So, what is the best way to pay yourself as a director?
Taking all the above taxes together, In the 2021/22 tax year, the monthly salary amount should also usually be set at the National Insurance Secondary threshold which is £736.66 per month, or £8,840 per year.
As we mentioned at the start of this Blog, the Lower Earnings Limit is below the point at which you pay employee or employer’s NICs, you will 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 will not pay any Income Tax or National Insurance on it if it is your only earnings.
We usually recommend this option based on tax efficiency. There could 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 are paid, but you may wish to get some advice to ensure you are paying yourself in the most tax-efficient way.