Consider £100 worth of excess profit in the company that you're considering paying out as a dividend. If you keep it in the company, let's assume you pay UK company tax of 19%, leaving £81 after tax. If you draw it out as a dividend, you say you'd pay 32.5% personal tax, leaving £67.50 after tax. This is the principal to invest.
Let's grab a convenient index fund, say the "Vangard FTSE UK Equity Income Index A" that's currently listed as yielding 4.40%. Assume this rate holds for a full year (it's a rubbishy assumption, but you can plug in any number you like).
Investing your principal P for one year produces
- P x Yield% income;
- P x Yield% x (1 - Tax%) after that income has been taxed; leaving
- P + [P x Yield% x (1 - Tax%)] in the bank, including your principal.
That's an effective (compounding) return of R = 1 + Yield% x (1 - Tax%).
Plugging in the assumed numbers above, after one year:
- retained in the company: 81 x (1 + 4.4% x 81%) = £83.89 approximately; or
- in your hand: 67.5 (1 + 4.4% * 100%) = £70.47.
After n years, your principal grows to P x R^n. Leaving the money in the company works out better until about year n=23, when the original before-tax £100 grows to about £181.25 in the company and about £181.75 in the ISA (after tax, assuming compound interest, all rates stay the same, no rounding each year, yada, yada).
The ISA wins after 23 years in the scenario above.
Company funds will need to be drawn as dividends if you want to access them, meaning that you will need pay additional tax upon finally declaring a dividend, in which case you come out in front with the ISA earlier. The return formula has a different tax rate in the final year, so it changes to:
- Return after final tax in your hand = P x R^(n-1) x [1 + Yield% x (1 - PersonalTax%)]
Assuming the personal tax is still 32.5% on dividends and 0% on ISA returns at the end of the exercise, you break even about a year earlier (about year 22 instead of year 23).
Of course, we can't expect yields and tax rates to remain constant over the long haul, and I don't know whether there's any expectation that the zero-tax ISA would survive decades intact. Feel free to punch the formulae into a spreadsheet and change the numbers to your heart's content.
UPDATE: the above assumes that franking credits avoid a double hit of company tax and personal tax on dividends. However, it seems that this isn't the case in the UK any longer:
From the 6 April 2016, there was a change to how dividends are treated in the UK. There are no longer any franking credits or tax credits that are attached to dividends paid, they have moved towards individuals paying tax based on the value of the dividends they receive.
- PJT Accountants & Business Advisors
To adjust the above, take the principal P from after-tax company income. That means the retain-in-company case has P=£100 and the ISA case has P=£67.50. The formulae remain the same, but with the much larger disparity in principal amounts, break-even only happens in around year 48.
At age 35 now and with a retirement age of 65, if you're drawing the dividend at year 30, it makes more sense to keep the money in the company instead of using an ISA.