After wrapping up their tax affairs for the 2018/19 tax year, many limited company contractors will only now be waking up to the reality of the 2018 dividend allowance cut, which saw the tax-free dividend allowance drop from £5,000 to £2,000.

In 2018/19, this tax-free allowance was applied to the first £2,000 of dividend income. Above £2,000, dividends are taxed at a flat rate according to the tax band they fall into.

For basic rate taxpayers, dividends are taxed at 7.5%, higher rate earners pay 32.5% and additional rate payers are taxed at 38.1% on any dividend income.

The dividend allowance was cut from £5,000 to £2,000 in April 2018. As a result, limited company contractors will have between £225 and £1,143 worse off depending on which tax band they are in.

Unless they are fall foul of IR35 (in which case they would have to pay income tax and National Insurance as if they were an employee), most limited company contractors will benefit from extracting most of their income in the form of dividends and retaining a small salary.

Chiefly, this is because dividends are not subject to National Insurance Contributions.

The optimum dividend-salary mix for contractors in 2019/20

In the current tax year, most contractors will benefit by paying themselves an annual salary between £6,136 and £8,632.

The £6,136 figure is known as the ‘lower earnings limit’. This is the minimum that you need to pay yourself if you want to protect your National Insurance stamp, which is important if you want to receive the state pension later in life.

Many contractors will be better off limiting their salary to £8,632, because if you pay yourself above this level then you start paying Employee’s National Insurance.

The typical limited company contractor can optimise their dividend-salary mix by paying a salary no higher than the primary threshold of £8,632.

This is within the personal tax free allowance of £12,500 for 2019/20 so there should be no personal tax to pay on this salary if you have no other source of income.

Please note that this is general advice and will not be the optimum mix of salary and dividends for many contractors. For advice that’s personalised to your situation, speak to a member of our accountancy team today. Call: 0800 121 6513.

What about IR35?

Many more contractors could find themselves £1,000s of pounds worse off each year if they fall foul of IR35 reforms set to be introduced next year.

From April 2020, limited company contractors operating in the private sector will no longer be able to judge their own IR35 status. This responsibility will instead fall to the private sector engager, in line with similar rules introduced in the public sector in 2017.

This change will almost certainly result in many more contractors being classed as ‘inside-IR35’ and forced to pay income tax and National Insurance Contributions as if they were an employee of the private sector organisation.

When it comes to salary and dividends, these IR35 contractors have no choice. They will be treated like any other PAYE employee, but may not get some of the benefits and perks that come with traditional employment.

Miles Grady, Director of Umbrella.co.uk, said: “Many contractors that are stuck with inside IR35 contracts will be better off joining an umbrella scheme. Umbrella contractors will still be taxed as regular employees, but they will also enjoy more of the perks and benefits, such as full employment rights, that come with working for an umbrella company.

“Contractors should be wary of any ‘umbrella’ scheme that offers a discount on tax liability. These schemes are, at best, highly contentious and, in most cases, illegal.”

For more information about or umbrella scheme or financial services for limited company contractors, speak to a member of the team today. Call: 0800 121 6513.