The 2015 Summer Budget has introduced a number of tax reforms which will impact contractors. In this post we’ll cut through the rhetoric, explain what the budget actually means, and a few practical steps you can take to lessen the impact.
First, let’s focus on the positive take outs for contractors:
Corporation tax reduction
Corporation tax (the tax on your company’s profits) will fall from 20% to 18% by 2020.
Increased personal allowance
The personal tax-free allowance will increase from £10,800 to £11,000 in April, ultimately rising to £12,500 by 2020.
Increased higher rate tax threshold
The higher rate tax threshold will be increasing from £42,385 to £43,000 next year, ultimately rising to £50,000 by 2020.
An increase in the Employment Allowance
This is a double edged sword. If you’re currently employing someone else in your company, you can benefit from an increase in the Employment Allowance – the discount on employer’s National Insurance contributions. From next year this will rise from £2,000 to £3,000. However, if you’re not currently employing anyone then this benefit will be removed – more on this in a moment.
A £5,000 tax-free dividend allowance
There are big changes afoot to the way dividends are taxed. Going forward all dividend income will be taxed (again, more on this in a moment), but the first £5,000 of dividend earnings will be free of tax.
Dividend tax credit
Contractors currently benefit from a dividend tax credit, which reduces the amount of tax paid on dividends. From April 2016 this will be abolished and will be replaced by the tax-free dividend allowance.
Increases in dividend tax
From April 2016 the tax you pay on dividends will increase by 7.5%, including basic-rate tax payers who don’t currently pay tax on dividends. As most contractors take money from their companies as dividends the majority will see an increase in the amount of income tax they will pay.
If you’re a one-person limited company, you’ll no longer be able to take advantage of the Employment Allowance.
The government is committed to toughening up IR35 legislation – expect more announcements later this year.
Three things you can do today
Given so many changes that impact contractors, you may be left scratching your head as to the real financial impact. Broadly speaking, you can expect an increase in your personal tax liabilities over the next five years. We can’t yet give you an exact figure as the government is yet to provide details on the practicalities of the reform. You will, however, continue to be significantly better off using a limited company than an umbrella / PAYE.
Remember, as always, that you’ll take a tax hit when you draw money out of your company, and the more you withdraw the larger your tax bill. On this basis, here’s three practical things you can do today to reduce your tax liabilities:
Keep more money in your company
The changes announced in the budget impact you at the point at which you personally draw down on your company’s earnings: it’s actually a good news story for keeping money in your company.
Now is a good opportunity to review how much you’re paying yourself. Are you drawing too much out of your company? Do your earnings flow in to personal investments and savings? If so, can you afford to pay yourself less, keep money in your company and lower your tax bill?
You can hold back profit in your company to invest in company-held shares, pensions, relevant life policies, properties, business ventures – there are countless opportunities if your personal finances allow it. You could even just hold back your earnings for a rainy day, or an extended career break.
Invest in a pension
Pensions are still the most tax efficient means in which to withdraw earnings from your limited company. If you’re not paying in to a pension, you’re missing out on incredible tax-saving opportunities. Talk to your IFA for advice.
Consider your exit plan
Savvy business owners realise that it’s tax-efficient to wind up a company with retained profit. It allows you to extract the profit from your company as a capital gain (with tax rates as low as 10%), rather than income (which can be as high as 45%), therefore reducing your tax burden. It’s another good reason to hold your profit in your company and minimise your personal drawings.
Remember all of the benefits
I saw an interesting comment this week from another accountancy firm, who said that the budget “may also stretch the sheer viability of contracting, potentially to breaking point”. That is a rather dramatic response: if a small increase in taxation leads you to question the viability of contracting, I would challenge you to remember why you started contracting in the first place.
Large organisations value flexibility and scarce expertise, and will pay for this in their daily rates. In return contractors enjoy a varied lifestyle, and, on the whole, a much better work/life balance, as well as greater take-home pay. The good news is that you always will be better off, no matter what the tax regime.
Seasoned contractors are no stranger to budget announcements such as this. This industry has seen reforms and revolutions many times over the last few decades. Those that fair well in the long term are those that understand that contracting does pay more than being a permie, but the benefits are far greater than just financial.