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Assuming:

  • I am an LTD director
  • I reach the higher tax band (32.5%) for dividends to cover my living expenses

Does it make financial sense to declare higher dividends (taxed in my hands at 32.5%) to invest in index funds through an Individual Savings Account?

The goal of the investment would be retirement. I am 35 now.

  • Can you please clarify what does "withdraw over the tax bracket" entail? What exactly are you withdrawing - the dividend sitting in your account, the underlying asset that generates the dividend, or something else? – B.Liu Sep 29 '18 at 18:58
  • @B.Liu it should have been "the higher tax band". I've edited the question to be better understood. Hope it makes sense now. – matewilk Sep 29 '18 at 21:18
  • I've edited your question for clarity. Please feel free to roll back the changes via the revisions link or to edit further. – Lawrence Sep 29 '18 at 21:51
  • So the basic point is that you have money in your LTD company that you can choose to pay out as dividends? And the amounts you are already paying to cover living expenses pushes you into the higher tax band, so the question is whether to pay out more dividends still in order to invest? – Ganesh Sittampalam Sep 29 '18 at 22:03
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    Are you already maxing out your pension contributions? – Ganesh Sittampalam Sep 29 '18 at 23:24
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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.

  • So if your calculation is correct, assuming I want to invest for more then 5 years, it would make more sense to invest outside of the company. How would it change if the dividend tax was let's say 20%? Could you give me a formula? – matewilk Sep 29 '18 at 22:58
  • @matewilk that's why putting it in a pension makes more financial sense – Neuromancer Sep 30 '18 at 20:20
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I can think of five different routes for your money you should evaluate against each other, based on the amounts involved, and your own guesses at to what growth you might get and how future tax rates will evolve.

Let's assume that all the vehicles allow you the same investments, which is true of index funds but perhaps not true of all investments. Then the natural growth rate you can expect is the same in each case, though it might be subject to tax. Let's call the annual growth rate Yield, and the number of years before you withdraw n.

  1. Leave the money in the company and invest it there.

    The growth will get hit with corporation tax every year. It's also possible your company would end up being seen as primarily for investing rather than trading which could have tax consequences: I'm not familiar with this area but I found some references here and here.

    Corporation tax rates are in flux at the moment and will also be different if your company does get seen as primarily for investing, but if we assume the current 19% rate and that you are a basic-rate taxpayer when you finally withdraw the money, the end result is 92.5% * (1 + 0.81 * Yield)^n.

    If you are a higher-rate taxpayer when you withdraw the money then the end result is 67.5% * (1 + 0.81 * Yield)^n.

  2. Withdraw the money now and invest in an ISA.

    This has a limit of £20K/year (or £16K/year if you use a Lifetime ISA too).

    After n years you'll end up with 67.5% * (1 + Yield)^n

  3. Withdraw the money now and invest in a Lifetime ISA, up to the limit of £4K/year until you turn 50.

    This comes with a 25% bonus, but you can't withdraw before you are 60 except to buy your first house. If you do withdraw before 60, you get a 25% penalty on the amount withdrawn, which amounts to losing 6.25% on your original investment as it's 25% of the new amount.

    So if you wait till 60 or use it for a first house then you'll have 84.3% * (1+Yield)^n.

    If you take it out early you'll have 63.2% * (1+Yield)^n.

  4. Pay it into a pension and invest it there, up to the limit of £40K/year (less if your gross personal income is more than £150K/year).

    You can pay in gross directly from your company, and can only take it from approximately age 58 (I think it's now set as state pension age - 10 years).

    As long as your total fund stays below the lifetime allowance, currently £1mn but expected to grow with inflation in future, you get to take money out at your marginal income tax rate at the time. You can also take out 25% tax-free. So assuming tax rates don't change:

    If you're a basic-rate taxpayer by then, you'll end up with 85% * (1+Yield)^n.

    If you're a higher-rate taxpayer still, you'll end up with 70% * (1+Yield)^n.

    If you go over the lifetime allowance, you effectively end up penalised by another 25% on top of your marginal rate of tax. You'd also probably be a higher-rate taxpayer so for any excess above £1mn, you'd end up with 45% * (1+Yield)^n.

    You should be able to avoid this last scenario by limiting your total contributions though.

  5. Withdraw the money now and invest it directly, outside any tax-free wrapper.

    The growth gets taxed at your marginal tax rate each year. So if you stay as a higher-rate taxpayer, you'll end up with 67.5% * (1 + 0.6 * Yield )^n.

    This option only really makes sense if you need to withdraw from your company for other reasons and you've maxed out the tax-advantaged personal options you are happy to use.

For the cases where your growth is taxed every year, the actual impact depends on the Yield and n. If you assume that the Yield is say 4%, the cost amounts to roughly 7% every 10 years for the 19% corporation tax rate, and roughly 14% every 10 years for the 40% higher-rate tax rate.

  • Actually for 4 you could look at salary sacrifice into the pension which would save on NI and also reduce tax paid at the higher rate. – Neuromancer Sep 30 '18 at 20:21
  • @Neuromancer If you own the company making the payments you don't need salary sacrifice to achieve that, you just make an employer's contribution directly. Salary sacrifice schemes are just a formal way of doing that in a larger organisation with a genuine separation between employer and employee. – Ganesh Sittampalam Sep 30 '18 at 20:24
  • Are you totally sure salary sacrifice is pre tax and you save on NI on both the employer and employee side so its actually better than paying more post tax in most cases – Neuromancer Sep 30 '18 at 20:28
  • @Neuromancer Salary sacrifice is just about giving up your contractual entitlement to salary in exchange for a higher employer contribution. Employer contributions are implicitly free of employer/employee NI and income tax. That's what I was assuming in my answer when I mentioned paying it gross directly from the company. – Ganesh Sittampalam Sep 30 '18 at 21:06

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