If you trade as a limited company, the chances are that you pay yourself a dividend each year to take advantage of your dividend allowance and reduce the amount of national insurance you have to pay.
This is usually a straightforward decision based on your retained earnings and cash availability. For 2021/22, the dividend ordinary rate is 7.5%, the upper dividend rate is 32.5%, and the additional dividend rate is 38.1%.
From 6 April 2022, these rates are all increased by 1.25%, such that for 2022/23, the ordinary dividend rate is 8.75%, the upper dividend rate is 33.75%, and the dividend additional rate is 39.35%.
So it may be worth reviewing your dividend policy sooner rather than later. In deciding whether it is beneficial to pay additional dividends before 6 April 2022, you should compare the rate at which they would be taxed if taken in 2021/22 with the rate at which they would be taxed if taken in 2022/23, taking account of the tax band in which they fall, and choose the option resulting in the lowest tax rate.
What is changing?
From 6 April 2023, a new health and social care levy (HSCL) is being introduced to provide ring-fenced funding for health and adult social care. The levy is linked to National Insurance contributions (NICs), and payable by those who pay a qualifying National Insurance contribution, or would who do so but for the fact that they have reached state pension age.
Prior to the introduction of the levy, NICs (with the exception of Classes 2 and 3 NICs) are increased for 2022/23 only; the funds being raised by the temporary increase being set aside to meet health and social care costs.
As payment of the HSCL is linked to NICs, anyone who does not pay a qualifying National Insurance contribution (other than those who have qualifying earnings but who have reached state pension age) will not pay the HSCL.
Individuals with personal and family companies will typically follow a tax-efficient profits extraction strategy comprising a small salary plus dividends. The salary level is typically at least equal to the lower earnings limit for primary Class 1 NICs purposes and, unless the employment allowance is available, not more than the primary threshold.
For 2021/22, assuming that the personal allowance is not used elsewhere, an optimal salary is one equal to the primary threshold of £9,568 where the employment allowance is not available (as is the case in a personal company where the sole employee is also a director), and one equal to the personal allowance of £12,570 where the employment allowance is not available.
One of the advantages of a profit extraction strategy of this nature is that little or no NICs is actually payable, while the year qualifies as a qualifying year for state pension and contributory benefit purposes. This also means that, come April 2023, there will be little or no liability to the HSCL either.
Not surprisingly, the government has addressed this to ensure those who take dividends rather than a salary will contribute towards the costs of health and social care by increasing the rates of dividend tax by the same amount as the levy (i.e., 1.25%). The increases take effect from 6 April 2022 – one year before the start of the HSCL, but at the same time as the temporary NICs increases (also set at 1.25%) come into effect.
While the playing field is not quite level (as the starting point at which dividends are taxed differs from the starting point for Class 1 and Class 4 NICs and the HSCL), the measure ensures those operating through personal and family companies and extracting profits in a way that results in little or no NICs being payable will be required to pay towards health and social care costs. The increase in dividend tax rates will also affect those receiving dividends from investments in shares.
However, as the dividend increases do not come into effect until 6 April 2022, there is still time to review your 2021/22 profit extraction policy and (profits permitting) take action to beat the tax rises.
Impact of dividend tax rates
All individuals receive a dividend allowance in addition to their personal allowance. For 2021/22, this is set at £2,000. Dividends which are sheltered by the allowance are taxed at a zero rate. Dividends are treated as the top slice of income, and the dividend allowance uses up part of the tax band into which it falls.
To the extent that dividends are not covered by the personal allowance or the dividend allowance, they are taxed at the dividend ordinary rate to the extent that they fall within the basic rate band, at the dividend upper rate to the extent that they fall in the higher rate band, and at the dividend additional rate where they fall in the additional rate band.
The impact of this is that if the same profit extraction policy is followed in 2022/23 as in 2021/22, for every £10,000 of dividends paid in excess of the dividend allowance and the personal allowance, an additional £125 of tax will be payable in 2022/23 compared to in 2021/22.
Is it worth paying dividends before 6 April 2022?
Dividends are paid out of retained profits. These are profits on which corporation tax has already been paid. You can only pay a dividend if you have sufficient retained profits from which to pay it.
Assuming you have sufficient retained profits, it may be worthwhile paying further dividends before 6 April 2022 to take advantage of the lower dividend tax rates applying for 2021/22. This is likely to be beneficial if you have not used all your basic rate band. In a family company scenario, it may also be worthwhile paying additional dividends to family members to further benefit from the 2021/22 rates.
However, in determining whether this is worthwhile, it is also necessary to consider whether paying higher dividends in 2021/22 will push those dividends into a higher tax bracket, negating the tax-saving benefits.
Example 1: Accelerated dividend
John provides consultancy services through a personal company. For 2021/22, he is paying himself a salary of £9,568. He also plans to extract £15,000 by way of dividends. He has no other income.
Applying this strategy will mean that John will have total income of £24,568, which will use up £11,998 of his basic rate band (i.e., £24,568 – £12,570), leaving £25,702 available.
After allowing for his planned dividends of £15,000 for 2021/22, John has retained profits of £20,000 remaining available. He expects to make a further £30,000 of post-tax profits next year and plans to apply the same profit extraction strategy as in 2021/22.
John could consider taking the remaining £20,000 of retained profits as a dividend this year, paying tax at the 2021/22 ordinary rate of 7.5%. If he extracts these profits after 6 April 2022 in addition to his normal salary and dividend, he will pay tax at 8.75%. Taking them before 6 April 2022 could save £250 in tax (£20,000 @ 1.25%).
Example 2: Which tax year?
Jane has rental income of £14,000 a year, which utilises her personal allowance. She also has a personal company through which she undertakes gardening work. She extracts profits solely as dividends.
In 2021/22, she has taken £35,000 of dividends. After taking the dividends, she has retained profits of £25,000 remaining. She is planning to semi-retire and expects her profits to fall to £10,000 after tax next year.
Jane has used up £36,430 of her basic rate band for 2021/22, leaving £1,270 available. She could take a further £1,270 of dividends in 2021/22 to take advantage of the 7.5% ordinary dividend rate applying for 2021/22. However, if she takes any further dividends in 2021/22, they will be taxed at the dividend upper rate of 32.5%.
While the dividend rates in 2021/22 are lower than in 2022/23, as Jane expects her income to be lower next year, she may be better delaying extraction of the remaining £23,730 of retained profits until after 5 April 2022.
If these were extracted in 2022/23, along with the expected profits of £10,000, the dividends would fall within the basic rate band and be taxed at the dividend ordinary rate of 8.75% for 2022/23. As this is lower than the upper dividend tax rate of 32.5% applying for 2021/22, Jane will pay less tax if she takes these profits as dividends in 2022/23, rather than in 2021/22.