Setting up a limited company can be a great option for self-employed people, but the tax rules around this are often complex and tricky to understand.

If you have a limited company, you must decide how the company will pay you a salary. Many accounting experts will recommend paying part of your income via a salary and part through dividends. You would be paid in the same way as any employee, with you being named as a company director.

A different system applies to sole traders. If you do go down the limited company route, then you must ensure you run the company payroll as per the Real Time Information (RTI) rules laid out by HMRC.

Why pay yourself a salary?

There are two key benefits involved in taking a salary from a limited company. The salary is an allowable business expense, thus it lowers company’s corporation tax bill. There could also be implications for your state pension: if your salary is higher than HMRC’s Lower Earnings Limit (which is £6,240 for the 2020-2021 financial year), then you will accumulate qualifying years for your state pension.

Why pay yourself a low salary?

If your salary is below a certain level, you may not have to pay National Insurance or even Income Tax. UK taxpayers are allocated a ‘personal allowance’ each tax year, meaning that all income under this amount is not subject to Income Tax. For 2020-2021, you would thus not be taxed on the first £12,500 of your income.

National Insurance has its own thresholds, and there are three main tiers. The first is the Lower Earnings Limit as mentioned above. If your salary exceeds this threshold, your state pension contributions will continue. The next tier is the Primary Threshold. If your salary is under this, you are not liable for employee National Insurance Contributions (NICs). For 2020-2021, this is £9,500 per year. The Secondary Threshold has connotations for Limited Companies, as the company will pay employer NICs once a salary exceeds this. Perhaps surprisingly, the Secondary Threshold is currently a little lower than the Primary Threshold, at £8,788 per year for 2020-2021.

The ideal is to take a salary that exceeds the Lower Earnings Limit, so you will qualify for your state pension. If you also keep the salary under the Secondary National Insurance threshold, it’s possible to avoid paying employee or employer NICs.

Why pay yourself a higher salary?

Despite the advantages outlines above, there can be certain disadvantages in taking a low salary. The ‘office holders’ of limited companies are not governed by National Minimum Wage regulations, unless they have a contract of employment. This means that a director might not qualify for maternity benefits, as they are not treated as ‘employed’ by HMRC.

Paying a low salary also means you might not benefit from your entire Personal Allowance. Should you need to claim on health, personal accident or critical illness insurance, any payout would be based on your earnings. You may also struggle if applying for a mortgage or loan and your salary is low, although a specialist mortgage broker should be able to find a way around this

How could National Insurance Thresholds affect my salary?

As we mentioned, the Primary Threshold is actually higher than the Secondary Threshold at the moment. One implication of this is that setting your salary at the Primary Threshold would mean paying employer NICs, thus reducing company profits. This would also lead to the reduced availability of dividends. For the 2020-2021 tax year, the most tax-efficient company director salary (who has no other taxable income sources) would be £8,788 for the year (£732.33 per month), as this matches the Secondary Threshold.

Why pay yourself in dividends?

Any profit made by a limited company can either be reinvested into the business, or paid to shareholders (company owners) via dividends. If it is your limited company, you are permitted to pay yourself a dividend. As less personal tax is due on dividends, this can be tax efficient. You can therefore combine dividends with a salary to ensure maximum tax efficiency.

What are the tax implications of paying yourself a salary?

All salaries are subject to Pay As You Earn (PAYE) tax. If you lower Corporation Tax liability by paying yourself a higher salary, this may be outweighed by the additional PAYE tax due. All sources of income are added together when calculating income tax liability. For instance, if £10,000 earned from employment in the 2020-2021 tax year was deducted from your Personal Allowance of £12,500, this would leave £2,500 Personal Allowance remaining.

Paying employee National Insurance

NICs work differently, as separate employment is subject to a separate earnings threshold. There is also a maximum limit on the amount of NICs due that is applied to Higher Rate taxpayers. Employees have a monthly threshold, paying NICs on any amount over this. Directors, however, have an annual threshold. If your salary exceeded this, NICs would then become payable.

Paying employer National Insurance

Employer NICs work very much in the same way. For every pound earned above the weekly National Insurance threshold, the employer is liable for NICs (currently paid at a rate of 13.8%). This applies to any director salary.

Making sense of director’s salaries

In summary, for the 2020-2021 tax year, the most efficient salary amount would be set at the Secondary Threshold for National Insurance – £8,788 per year. One reason for this is that exceeding the Lower Earnings Limit means you will build up your state pension entitlement. If a salary is paid from your limited company up to the relevant National Insurance threshold, no Income Tax or National Insurance would be due, provided you have no other earnings. In some cases, however, there are reasons to pay yourself a higher salary.

Here at Adaptive Accountancy, we can help you decide the most tax-efficient way to pay yourself from a limited company. We offer all sorts of limited company accountancy services in South Yorkshire, so do get in touch if we can help to reduce your tax bill.