Do contractors really pay less tax?

Sooo… taxes.

How do they work? Do you actually pay less than if you were a permanent employee?

First of all, this is not financial advice. If you start a company you should always get an accountant and follow the advice that they give you. I am not qualified in finance in any way shape or form, this is just based on what I’ve learnt being a contractor the last few years.

Now how do taxes work for a contractor?

Inside IR35

For Inside IR35 roles, nothing really changes compared to permanent positions. You’re going to have an employer who taxes your income at source, before it gets to you.

There isn’t any real tax benefit to working as an Inside IR35 contractor. The main difference compared to perm is that your day rate could be high enough that you could still be making more than if you were a perm employee for the same role. IF the rate is high enough. But the method of tax is no different to employees.

As a side note: you're not employed by the company you're doing the work for (or you'd just be a normal employee). You're usually employed by the recruitment company who found you the contract, or a third party payroll ("umbrella") agency that they work with. This isn't that relevant for tax purposes, but worth noting.

Outside IR35

Now for Outside IR35, things are a little different. For these types of roles, you’re an employee of you’re own company. Your company is providing a business service to the client. It’s a business to business relationship. You just happen to be the contractor for your company that’s doing the work. You and your company are also responsible for dealing with taxes, not the client. They pay your company the full amount for the work you’ve provided.

This means that when the client pays you, they do not pay you personally. The money goes into your company’s bank account. At this point, any money here only belongs to your LTD company, not you personally. No tax has been deducted at this point.

To clarify further, you and your company are two separate legal entities. You can’t just go spending that money in the company bank account on your own personal things.

So how do you get the money out of the company and into your own possession? There’s two ways: a salary, and dividends.

Paying yourself

The income tax threshold for employees for the 2023/24 tax year is as follows:

Personal Allowance	Up to £12,570	0%
Basic rate	£12,571 to £50,270	20%
Higher rate	£50,271 to £125,140	40%
Additional rate	over £125,140	45%

Let’s say you’ve paid yourself £5,000 per month as a salary. Over a year, that’s £60,000. Because you’ve taken it out as a salary, you need to pay normal income tax on the entire amount, same as you would have as a normal employee. The same goes for national insurance contributions.

So the tax for that £60,000 salary is broken down as follows:

Gross Income	£ 60,000.00
Taxable Income	£ 47,430.00
Tax at 20%	£7,540.00
Tax at 40%	£3,892.00
Total Tax	£ 11,432.00
National Insurance	£ 3,964.60
Take Home	£ 44,603.40

You've paid a total of £15,396.6 in combined income tax and national insurance. This is the same as an employee with a normal job, or an Inside IR35 role. So you don’t really do this as an Outside IR35 contractor, it kind of defeats the point.

Instead, you take some salary out, but then take out most of your personal income as dividends from the company. Why? Because dividend tax is lower than salaried income tax. Here's the dividends tax thresholds for the 2023/24 tax year:

Basic rate	8.75%
Higher rate	33.75%
Additional rate	39.35%

How much dividends tax you pay still depends on which income tax band you fall into (the first table). So they add up all of your income, and based on which threshold you fall into, that determines the dividends tax you pay.

So in our example of making £60,000, if you were to take out £8000 as a salary, and £52,000 as dividends, here's how that would break down:

Gross Income	£60,000.00
Dividend Tax Allowance	£1,000.00
Taxable Dividends	£46,430.00
Basic rate	£3,211.00
Higher rate	£3,282
Total Tax	£6,495.00
Take Home	£ 52,505.00

You subtract your dividend allowance (£1000) and personal allowance (£12,570) from your gross income (£60,000), to get your taxable amount of dividends (46,430). You don't pay any income tax because your salary (£8000) is less than your personal allowance.

The reason you don't pay any national insurance in this example is because NI has it's own thesholds as well. Your accountant will usually tell you what the optimal amount of salary is for you to not have to pay national insurance, while still being eligible for state pension. This is also why it may not be a good idea to take out £0 salary.

At the end of it, you've been paid the same gross amount, but have ended up with more money in your pocket as a result of being an Outside IR35 contractor.

Points of nuance

• The above examples assume assume that you have no other sources of income. When calculating how much tax you should pay, HMRC will take into account all of your income.
• Your company has to pay Corporation Tax annually. I've left this out from the above examples because it's specific to your company, not your personal taxes. But as of writing, it is 19% of your company profits.
• You pay Corporation Tax before you pay yourself dividends (or at least account for them, your accounting software helps you do this).
• After the financial year ends (April 5th every year), you submit a Self Asessment form, and you have until the following January to pay the tax you owe. So you're not paying tax every month like you normally would as an employee.
• For Outside IR35 contracts, you have to make sure you really are behaving as a business, and not pretending to be just to pay less tax. This is referred to as disguised employment, and is the reason IR35 exists to begin with. If HMRC finds you've been working contracts that are similar to employees in structure, but handling tax as if they were Outside IR35, they could ask you for back taxes.

For more details about the differences between Inside/Outside IR35, you can refresh yourself here.

Tips

• I did recently come across this video on accounting and contracting that I thought was really insightful. I’d never come across the channel before, but a lot of the content in this specific video would of been quite helpful in my understanding of taxes and contracting when I started, so I recommend watching it.

• The biggest tip I can give you around taxes as an Outside IR35 contractor, is to be putting money aside every month for you tax bill. Because tax is not being deducted every month like it used to be as a permanent employee, it’s easy to forget that not all of this money you’ve paid yourself is all yours. And you end up spending it all, then realising at the end of the year you have a hefty Self Assesment Tax bill that you haven’t prepared for. So save money aside as you go!

• The second biggest tip is as a company director, you don't have to pay yourself everything your company makes. It's sometimes more tax efficient to leave money inside your company, and pay yourself what you need to.

I’ll also remind you once more though, none of this is financial advice :)

Thank you for reading! If anything here is a bit confusing, or you'd like further clarity. Feel free to reach out and ask / let me know!