IFA's guide to avoiding the new dividend tax
In wake of Summer Budget 2015, ContractorUK asked IFA ContractorMoney to spell out the new dividend tax rules, and explain how contractors can reduce their tax bills when the dividend tax rates / bands come into force next year.
What are the new dividend tax rules?
From April 6th 2016, contractors operating via a limited company will be given a new £5,000 tax free allowance on dividend income. Any dividends that you draw out beyond that limit will be charged at 7.5% for basic rate taxpayers; 32.5% for higher rate taxpayers and 38.1% for highest rate taxpayers, which will need to be paid using the self-assessment system.
A good starting point to gauge the not insignificant impact of these new rates is ‘Contractor dividend tax tables,’ so you can see how you will be affected in the 2016/17 tax year.
What is the maximum I can draw out of my company before being hit by the new rules?
Dividends are eligible for the personal allowance so contractors can effectively draw up to £16,000 tax free in the next tax year as you benefit from the increased personal allowance of £11,000 from April 2016, and the £5,000 dividend allowance.
What happens with retained profits?
There haven’t been any changes relating to leaving money in your limited company so you will continue to pay 20% corporation tax on any profits and can choose to leave as much as you want to in the company as retained profits. If you want to draw these retained profits out of the company, then the new dividend tax rules will apply (from April 2016) unless you decide to close your limited company down completely. We expect to see some contractors leaving large sums in their limited company until they reach retirement or, perhaps, until some decide to return to permanent employment as a result of these new rules.
Is there anything I can do with retained profits rather than drawing a dividend?
There are a number of options that you can choose to make use of your retained profits and make that money work harder for you rather than gathering dust in your company accounts until you are ready to shut up shop. These options, which also have the advantage of minimising the effects of the incoming dividend tax reform, are explored below.
Company funded pension contributions
If you are currently paying a pension out of net income or don’t already have a pension in place then now is the time to set up a limited company pension. You can shift profits into a pension thereby bypassing corporation tax and you also head off the personal tax and dividend taxes that you would be forced to pay if you were drawing the income personally to contribute.
Remember, company pensions benefit from all of the flexibility rules that apply to a personal pension so you can still benefit from the chancellor’s changes to how you can drawdown an income from your pension pot. An annual allowance of £40,000 applies but other than that, there is no restriction as to how much you can contribute tax-efficiently, so you could reduce your corporation tax bill to nothing! You can then withdraw up to 100% of your pension at age 55 depending on your circumstances and retirement planning so pensions offer a win-win for contractors hoping to avoid the dividend tax altogether, especially if you are approaching the age of 55.
The really comforting news is that contractors are unlikely to be caught by the new adjusted income rules, as you are likely to be within the £150,000 earnings cap, and so you shouldn’t see your annual pensions allowance fall in the near future. Even if you were looking to make sizeable pension contributions that would take you over the £150k threshold (please note; the new rules take into accounts earnings, plus personal and employer pension contributions), as long as your salary and dividends were not in excess of £110k, then the adjusted income rules will not apply to you.
Limited company buy-to-lets
If you have been considering drawing a dividend to fund a buy-to-let purchase then you would definitely be hit by the new dividend tax rules. But don’t fret - you can now purchase a buy-to-let using a limited company without the need to draw that deposit out of your company – avoiding all the tax implications that involves. This is thanks to a new breed of limited company buy-to-let mortgage which is open to most contractors whether purchasing or planning to mitigate the tax on existing buy-to-lets.
In fact, contractors can now purchase investment properties through a new limited company which is a wholly owned subsidiary of their contracting company, allowing the deposit funds to be transferred between the two companies without a dividend drawdown. What’s more, as the limited company is ring-fencing the property and its income they won’t be caught by the new tax rules for landlords, saving thousands of pounds from 2017.
Once purchased, the buy-to-let profit can be reduced by offsetting 100% of the mortgage interest and any allowable operating expenses. The profit you make attracts corporation tax and can be retained in the company for further property investments or to pay down the mortgage at a later date.
Relevant Life Cover
If you are currently drawing an income personally to pay for your life insurance premiums then you should consider changing to a Relevant Life policy. These company funded policies enable you to pay for the premiums tax-efficiently through the company with no benefit in kind considerations.
By doing this, you not only reduce your corporation tax bill but you also save the income tax, NI or dividend tax that you will pay if you draw that income out to pay for a personal policy. Any pay-out is paid directly to your dependents as the policy is held in a trust so they won’t be left to draw the money out of the company and therefore won’t be liable for the new dividend tax on the lump sum. Although this is a relatively small saving in comparison with the pension or buy-to-let option, ‘every little helps’ as a well-known supermarket chain tells us.
Plan ahead
If you expect to hold a significant profit in your limited company this year then it may be wise to draw out a large dividend before George Osborne’s changes come in to play in April next year, so that you don’t have to worry until the 2016/17 tax year. This dividend rule was an unexpected blow to contractors in the 2015 Summer Budget, but if you utilise the tools above, there is no reason why contractors cannot turn these changes to their advantage.
Editor's Note: Related Reading -
When the dividend tax bits is the real rub
New dividend tax comes into force
Contractors' Questions: What to do about the dividend changes?
