Optimal salary for 2020/21
A popular profit extraction strategy for personal and family companies is to pay a small salary and to extract further profits as dividends. With new National Insurance thresholds applying for 2020/21, what is the optimal salary for the new tax year?
Starting point – what can be paid free of tax and National Insurance?
Assuming the director has the full personal allowance for 2020/21 of £12,500 available, the optimal salary will be dictated by National Insurance considerations. Unless the director already has the 35 qualifying years needed to secure a full single tier state pension, it is worthwhile paying a salary at least equal to the lower earnings limit, set at £6,240 for 2020/21, to ensure that the year counts for state pension and contributory benefits purposes.
For 2020/21, the point at which employer contributions start (the secondary threshold) is lower than the point at which employee contributions start (the primary threshold). The secondary threshold is set at £8,788 for 2020/21 (£169 per week; £732 per month), whereas the primary threshold is set at £9,500 (£183 per month; £792 per month).
Assuming that the director is over the age of 21 and the employment allowance is not available (as is the case where the sole employee is also a director), the maximum salary that can be paid free of tax and National Insurance is £8,788 – equal to the secondary threshold.
Employer contributions for under 21s do not start until the upper secondary threshold for under 21s is reached (set at £50,000 for 2020/21). Thus, where the director is under 21, a salary equal to the primary threshold of £9,500 per year can be paid free of tax and National Insurance. This is also the case if the employment allowance is available (for example, in a family company scenario).
Is it beneficial to pay a higher salary?
Salary costs and any associated National Insurance are deductible in computing the company’s profits for corporation tax purposes. Thus, if the corporation tax deduction (at 19%) is more than any National Insurance or tax paid on the additional salary, paying a higher salary can be worthwhile.
If the director is 21 or over and the employment allowance is not available, it is worthwhile paying a salary up to the primary threshold of £9,500. On earnings between £8,788 and £9,500, employer National Insurance contributions of 13.8% are due, but this is outweighed by the corporation tax deduction on the additional salary and the associated employer’s National Insurance. However, once the primary threshold is reached, both employer and employee contributions are due (at 13.8% and 12% respectively) on further earnings. As these outweigh the corporation tax deduction, it is not worth paying a salary above £9,500 a year. So, where the director is aged 21 or over and the employment allowance is not available, the optimal salary for 2020/21 is £9,500 a year (£792 per month).
If the director is under 21 or the employment allowance is available, as seen above, a salary of £9,500 (equal to the primary threshold) can be paid free of tax and National Insurance. Above this level, primary National Insurance contributions are payable at 12% until the personal allowance of £12,500 is reached. As the associated corporation tax deduction is higher than the National Insurance cost, it is worth paying a salary of £12,500. Above this, however, income tax at 20% is also payable, outweighing the corporation tax deduction. Consequently, in these circumstances, the optimal salary is equal to the personal allowance of £12,500 a year.
Determine your optimal salary
As shown above, the optimal salary depends on personal circumstances. Speak to us for help in crunching the number and determining the optimal salary for your situation.