understanding dividends

A guide to dividends and what you need to know as a Limited Company contractor

By Published On: 19 October 2020Tags: ,

For Limited Company contractors, dividends are a fantastic way to maximise your take home pay and increase your tax-efficiency, but getting your head around them can be a little tricky. Whilst it’s always a good idea to have the support of a specialist contractor accountant to help you get it right, it’s also important to have a basic understanding of what dividends are and how they work.

In this blog we look at just that, and give you an overview into the world of dividends.

What is a dividend?

In a nutshell a dividend is a distribution of company profits amongst the company’s shareholders. As a Limited Company contractor you’re able to pay yourself a salary, then top up your monthly income with dividends.

Dividends are taxed differently to salary, and many contractors add a spouse as a shareholder in their Limited Company so that they’re able to increase the amount of tax-free income they can draw out of their company.

When are you able to draw dividends?

You’re able to draw a dividend from your Limited Company whenever you wish, so long as there’s enough profit within the company. If there isn’t it would be classed as an illegal dividend or director’s loan, and could be subject to an investigation from HMRC.

Most contractors draw their dividends monthly, quarterly or annually. Whilst it’s up to you as to how often you draw dividends, if you do it too often it may be considered a ‘disguised salary’ and could also be subject to an investigation.

It’s also important to understand that when you decide to declare a dividend you must minute your decision, and provide all shareholders with a dividend voucher. By doing so you’re providing a clear audit trail should it ever be investigated, and all dividend vouchers are required for your annual tax return.

What are the tax and National Insurance Contribution (NIC) implications?

Dividends do not incur any NIC, and this is one of the main reasons why they are so favourable to contractors. Many contractors choose the combination of a low salary and high dividends, as it’s the most tax efficient way to pay yourself.

The dividends you do draw will be taxed as personal income, with a tax-free allowance of up to £2,000 per person. The following tax thresholds are correct for the current tax year:

Basic rate (taxed at 7.5%): up to £50,000

Higher rate (taxed at 32.5%): from £50,001 to £150,000

Additional rate (taxed at 38.1%): £150,001 +

A dividend is taxed at the point it is declared, rather than when it’s drawn, so it’s important to time this correctly to ensure it’s taxed correctly. For example, if you were to declare a dividend on April 1st 2021 but it wasn’t paid until April 7th, it will be included in your 2020/2021 tax return, which depending on how much you’ve already drawn during that tax year, could push you into the next tax rate.

Your contractor accountant will be able to advise you on this, and help you keep track of which tax rate you’ll be paying, whether it’s worth it for the amount you’ll be drawing, and when the best time will be to do so.

Final thoughts

Dividends are fantastic as they allow you to make the most from your personal allowances. By paying yourself a salary which doesn’t use up all of the basic tax rate then topping up your income with dividends, you’ll be making full use of the lower tax rate without having to pay any further NIC.

Every contractor’s needs are different, and your personal circumstances will determine how and when you decide to draw dividends. Whilst in principle the concept is simple, it can be very easy to draw too many dividends, thus tipping yourself over into higher tax bands. Always ensure you speak to a specialist contractor accountant before taking any money out of your business account, to ensure you’re taking the right amount and doing everything by the book.

If you’re on the lookout for a new contractor accountant, get in touch today. Our team of director-level accountants are on hand, ready to give you specialist dividends advice, and to help you take home the maximum amount of your contractor pay.

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