What are Dividends?

When a company makes a profit, it pays dividends to its shareholders.

If you have recently started a limited company, you have probably heard from other business owners about taking a low salary and using dividends to make up a portion of your income.

Dividends

When a company makes a profit, it usually retains a portion of its profit and distributes the rest to its shareholders in the form of dividends.

Why contractors and small business owners like dividends

The main benefits of dividends are:

• Unlike salary, dividends are not subject to National Insurance Contributions (NICs)

• The first £2,000 of dividends are not taxable

• Dividends have a lower tax rate than salaries

For tax year 2020/21, dividend tax rates are:

• 7.5% (up to £37,500)

• 32.5% (£37,501 – £150,000)

• 38.1% (over £150,000)

If you intend to declare dividends, you must hold a board meeting and minute it whenever you make a declaration. Then your accountant will prepare a dividend voucher for each company shareholder stating the net dividend paid.

Prior to the tax year 2016/17, the was something known as a notional 10% tax credit but HMRC has abolished this.

An example of dividend tax

In the tax year 2019/20, you receive a salary income of £8,600 and this is not subject to tax because the income is below the Personal Allowance threshold of £12,500. This also means you still have a balance of £3,900 left to use.

In the same tax year, you receive dividends worth £15,000 and out of this amount, you only need to pay a low 7.5% tax rate on £9,100. This is because:

• £3,900 of your £15,000 dividend income is tax-free since you have this balance from your Personal Allowance (£12,500 Personal Allowance minus £8,600 salary income)

• Another £2,000 of your £15,000 dividend income is also not taxed as you have a £2,000 Dividend Allowance

The upshot of it is you are only required to pay £682.50 tax on your £15,000 dividend income. This low rate is not achievable if you are drawing a salary. You must then declare this dividend income on your Self Assessment tax return in the ‘Dividends’ section.