The £100k Tax Trap for Limited Company Directors

Reaching £100,000 of personal income might sound like a nice problem to have. But in the UK tax system, going over £100,000 can make the next chunk of income surprisingly expensive.

For limited company directors, this is particularly worth watching. If you take a combination of salary and dividends from your company, you often have more control over the timing and amount of your income than a typical employee.

That makes a little forward planning important.

What actually happens when you go over £100k?

Once your adjusted net income goes above £100,000, your tax-free Personal Allowance starts to reduce.

For every £2 your adjusted net income exceeds £100,000, you lose £1 of your Personal Allowance.

The standard Personal Allowance is £12,570, so by the time your adjusted net income reaches £125,140, you’ve lost it completely.

It’s what happens between those two figures that creates what’s commonly known as the £100k tax trap.

Where does the 60% tax rate come from?

There isn’t actually a 60% Income Tax band.

The 60% figure comes from the combination of paying higher-rate tax and gradually losing your Personal Allowance.

As a simple example, imagine your income is £100,000 and you take another £1,000 of taxable income.

You would normally expect that extra £1,000 to be taxed at 40%, costing £400.

But because you’ve gone £1,000 over the threshold, you also lose £500 of your Personal Allowance. That makes another £500 of your existing income taxable at 40%, costing another £200.

So that additional £1,000 has effectively resulted in £600 of extra Income Tax.

That’s an effective tax rate of 60%.

Dividends count too

This is an important one for limited company directors.

Taking a relatively small salary doesn’t mean you’re nowhere near the £100,000 threshold.

Your dividends are also taken into account when calculating your income, along with other sources of taxable income.

So, if you’ve taken £12,570 in salary and £85,000 in dividends, for example, you’re already at £97,570 before considering things such as savings interest, rental income or other taxable income.

Another dividend could therefore push you into the area where your Personal Allowance starts disappearing.

It's not only the extra tax to think about

Going over £100,000 can have other consequences too.

One particularly important example for parents is Tax-Free Childcare.

If you or your partner expect to have adjusted net income of more than £100,000 in the current tax year, you generally won’t be eligible for Tax-Free Childcare.

That can make accidentally creeping over the threshold considerably more expensive for some families.

Should you just stop taking dividends at £100k?

Not necessarily.

The aim of tax planning isn’t simply to pay the smallest possible amount of tax at all costs.

You might need the money personally. There may be good reasons to take a larger dividend, and paying more tax because you’ve taken more income doesn’t automatically make it a bad decision.

What matters is understanding the consequences before taking the money.

If you’re sitting at £99,000 of income and considering another sizeable dividend, it’s useful to know what that dividend will actually leave you with after tax.

Could pensions help?

Pension contributions can sometimes form part of the planning around the £100,000 threshold.

Certain personal pension contributions can reduce adjusted net income, which may help restore some or all of a lost Personal Allowance.

Limited company directors may also consider employer pension contributions made directly by their company as part of their wider remuneration planning.

Pensions have their own rules and limits, though, and pension decisions shouldn’t be made purely for a tax saving. Where financial advice is required, this should come from an appropriately authorised adviser.

Don't wait until your tax return

The best time to discover you’ve crossed the £100,000 threshold isn’t when your Self Assessment tax return is being prepared months later.

By then, the tax year has finished and many of the decisions that could have been considered beforehand are no longer available.

Keeping an eye on your expected personal income during the year gives you the opportunity to plan your dividends rather than simply finding out afterwards what they have cost you.

And don’t forget about income outside your limited company. Interest, property income and other taxable income can all affect the final position.

A little planning can make a big difference

The £100,000 threshold isn’t something to be frightened of, and earning more money is still earning more money.

But it is a point where limited company directors should pay closer attention to how much they’re taking from their business.

Before taking that next dividend, it’s worth looking beyond the company’s bank balance and considering what it will do to your overall personal income.

At PaperRocket Accounting, we help contractors and small limited company owners understand their salary and dividend position and plan ahead for their personal tax bills.

If your income is approaching £100,000 and you’re wondering whether to take another dividend, speak to us before the tax year ends. Sometimes knowing the numbers beforehand can make all the difference.

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