Contractors’ Questions: When’s best to draw dividends and salary on maternity leave?

Contractor’s Question: I have limited company and I’m going on maternity leave for hopefully a year – albeit just as my tax year ends in couple of weeks! What consideration should I make?

For example, is it worth leaving the personal allowance of £12,500, plus the £2,000 dividend allowance, in the account, so I take it out next tax year (while on maternity leave), meaning I wouldn’t have to pay tax on either? Or does it not matter if I take it out now regardless of the 7.5% tax on dividends? Thanks for any efficiency tips!

Expert’s Answer: Firstly, can I offer my congratulations on your imminent arrival!

I’m going to assume that as you’ll have some additional expenses to cover in the near future, your main objective here is to take any money from the company in the most tax-efficient way possible. So let’s go through your likely options.

Dual assumptions

I’m going to assume that your limited company is 100% owned by you. If that’s not the case, and you have another shareholder, who has some unused basic rate band or dividend allowance (based on your, and their projection of the remainder of the personal tax year, running to April 5th 2021), then you might want to consider them in your choices.  Whether that’s a good idea will depend on detail I don’t have, but if that is the case, it’s worth taking further advice.

I’m also going to assume that you have a reasonable level of reserves (company profits after allowing for company taxation) in your company, which you’d need to take as dividends.  Of course, given the current covid-19 pandemic and the uncertainties for everyone in the foreseeable future, it’s hard to have much certainty about likely income levels, and possible changes to tax legislation. But let’s stick to the basics here.

You have three main sources of income: Regular payroll, maternity pay and dividends. The voting and payment of dividends requires that the company has reserves, and up to a point, so does the payment of regular salary, although you are allowed to be paid a wage even if that creates a loss. But as stated above, I’ll assume you have a reasonable level of reserves.

Let’s crunch the numbers

For regular payroll, if you don’t have any other taxable income, except that originating from the company to take, we’d normally advise a regular salary of £792 per month be taken, or £9,500 per year, as above this level, in addition to paying Employer National Insurance Contributions, Employee NICs become due too, which more than offsets the benefit of the salary being deducted against profits for corporation tax purposes! Assuming you’re asking the question now, I would therefore expect you’ve so far taken three or four months of salary at this kind of level in the current personal tax year. 

Once your maternity leave starts, you’ll have been receiving more than the maternity pay threshold of £118 per week, so assuming you’ve been taking this amount for at least 26 weeks, leading up to the 15th week before childbirth, then you’ll be entitled to maternity pay.

The good news is, it’s likely your limited company will qualify as a ‘small employer’ and so you’ll be able to claim back 103% of the maternity pay the company pays you. You’ll receive 90% of your previous average salary for 6 weeks, and then statutory maternity pay (£151.20) for the next 33 weeks, and you can claim all that back.

Fancy a small bonus?

If you wanted to be really clever, you could calculate the exact amount this will mean you’ve been paid via PAYE by the end of the 20/21 tax year, and if that’s less than £9,500, pay yourself a small bonus prior to the commencement of leave to fill it up! This won’t affect your average pay, as that’s calculated based on earlier weekly earnings, but you will be being tax-efficient, and it might help with some baby expenses.

So finally you should consider dividends. Any dividends which fall into your personal allowance of £12,500 this tax year, and the dividend allowance on top of that of £2,000, will be free of tax. If you’ve used the advice above to take £9,500 in payroll, then you can take a further £5,000 without tax charge during this tax year. If you’ve already taken some dividends this tax year (since April 6th 2020) then reduce the £5,000 by that amount.

Amounts of dividends that take total income above £14,500 are taxed as follows: 7.5% in the basic rate band, 32.5% until you reach £150,000 of total income (not forgetting that the personal allowance shrinks above £100,000 of total income), and 38.1% above that.

In summary…

So the key, overall, is to check you qualify for maternity pay, and claim that. Then check what point during the tax year you are at and where you’re likely to be by the end of it, and consider a PAYE top-up, but only to the tax-efficient maximum, and then use dividends for the remainder. You can take up to £14,500 of income in a combination of PAYE, maternity pay and dividends with effectively no tax charge, and reclaim a good portion of that back from the government. 

For completeness, if you end up with an accounting year with little or no income but some costs, apart from the maternity pay that you should be able to reclaim, you may create a loss for tax purposes, that could be carried back to the previous tax year, assuming there are taxable profits there. And finally, if you don’t have reserves of cash in the business, you can apply for maternity pay to be paid to the company in advance of it having to pay you.

If you need larger amounts of money sooner, then provided you have reserves, dividends will be the best option in almost every case. When you enter the next personal tax year in April 2021, you can start to fill up those bands again. And finally, as usual, make sure you confirm your situation and intended actions with your own accounting adviser!

The expert was Chris James, director of accounting services at JSA Services, and the chairman of the Freelancer & Contractor Services Association.