Five tax efficient ways to extract profits
Extracting profits from your business in the most tax-efficient way is one of the smartest financial decisions you can make as a business owner. Yet many directors and sole traders leave money on the table simply because they’re unsure which route offers the best outcome. The good news? There are several legitimate strategies available under HMRC rules that can help you keep more of what you’ve earned. Let’s explore five practical approaches.
1. Take a Salary Up to the Personal Allowance
If you’re a limited company director, one of the simplest moves is optimising your salary. For the 2024/25 tax year, the personal allowance sits at £12,570. If you pay yourself a salary at or just below this threshold, you won’t need to pay income tax on it. Better still, you’ll still build your National Insurance record and qualify for state pension contributions.
The current National Insurance threshold for employees is £12,570 annually (or £175 weekly), which aligns nicely with the personal allowance. Many directors pay themselves exactly this amount to maximise this benefit without triggering additional National Insurance costs.
2. Claim All Allowable Business Expenses
This is fundamental but often overlooked. HMRC allows you to deduct reasonable business expenses from your taxable profit, which directly reduces your Corporation Tax bill (currently 19% for profits under £50,000, and 25% for larger profits). Common allowable expenses include:
- Home office costs (working from home allowance or actual costs)
- Professional fees (accountancy, legal, and consulting)
- Equipment and tools
- Business travel and mileage (45p per mile for cars)
- Software subscriptions and IT costs
- Staff training and development
Don’t be shy about claiming legitimate expenses—they’re specifically designed to reduce your tax burden. However, personal expenses and costs that aren’t wholly and exclusively for business purposes won’t be accepted.
3. Distribute Dividends After Corporation Tax
Once your limited company has paid Corporation Tax, you can distribute remaining profits as dividends to shareholders. This is often more tax-efficient than taking everything as salary, particularly if you have co-directors or family shareholders.
For the 2024/25 tax year, each shareholder receives a £500 annual dividend allowance. Dividends within this allowance are tax-free. Above this, basic rate taxpayers pay 8.75% dividend tax, whilst higher rate taxpayers pay 39.35%.
The key advantage: dividends avoid National Insurance contributions (unlike salary), which can save approximately 12% compared to taking equivalent sums as wages. However, you must ensure your company has genuine profits available and maintains proper dividend documentation and board minutes.
4. Maximise Pension Contributions
Contributing to a pension is a powerful tax-planning tool. As an individual, you can contribute up to your annual earnings or £60,000 annually (2024/25 tax year), whichever is lower, and receive full tax relief.
If you’re a limited company, you can make pension contributions directly on behalf of yourself and employees. These contributions are deductible against Corporation Tax, reducing your profit and tax liability simultaneously. This approach is particularly effective for higher earners, as it reduces both income tax and National Insurance whilst building retirement savings.
5. Claim Research and Development (R&D) Tax Credits
If your business has developed new products, processes, or services, or solved technical problems, you may qualify for R&D tax credits. These are particularly valuable for tech firms, manufacturers, and engineering businesses, though they’re available across many sectors.
Depending on your company size, you can claim either:
- Small-to-medium enterprises (SMEs): Up to 19% of qualifying costs as a cash credit or offset against Corporation Tax
- Large companies: A deduction worth 12% relief
Many businesses don’t realise they’re eligible, so it’s worth reviewing your activities against HMRC’s guidelines.
Getting the Balance Right
The most tax-efficient strategy depends on your personal circumstances, business structure, profit levels, and long-term goals. Taking maximum salary works for some; for others, a combination of modest salary and dividends is optimal. The same applies to pension contributions—timing and amount matter significantly.
What works brilliantly for your friend’s business might be entirely inappropriate for yours. That’s why professional advice is so valuable.
For tailored advice, contact Severn Accounting — we’re here to help.