In the 100 years since its introduction, National Insurance has evolved from the nature of insurance to that of tax. As a result of this part-evolved state, it has many curious provisions that offer scope for some legitimate tax planning.
What is National Insurance?
National Insurance effectively taxes on any income that you earn over a certain level. These contributions go towards a number of benefits including your pension. While full-time employees have the comfort of knowing that their employer will manage their National Insurance, as a contractor, the responsibility falls to you.
It is important for you to be aware of your responsibilities as a limited company director so you can plan as effectively as possible.
Age and income source
You will not need to pay National Insurance contributions once you reach retirement age. This is currently 65 for men and is slowly increasing from 60 to 66 for women. If you can defer assessable income to after this age, you avoid National Insurance completely. By 2020, the age will be 66 for both men and women but your accountant can advise you on when you reach your state retirement age.
National Insurance is not payable on dividends, pensions or investment income. This means that it may be better to take an income from a company in the form of dividends rather than a salary.
Note that, following a case in 2009, this will usually not be effective for paying employees. There are some other implications in paying dividends rather than salary, which we can explain.
More than one source
Unlike income tax, the exempt band applies to each employee. In April 2011, the earnings threshold rose to £139. This means that significant savings can be made if the extra income comes from a second and unrelated employer.
For higher employed earners, care needs to be taken when earnings exceed the upper earnings limit. This is only £817 per year. Unlike income tax, the National Insurance rate reduces on earnings above this limit.
Income tax is charged at progressively higher rates on each slice of additional income. National Insurance, however, does the opposite.
If you earn above the threshold, you pay 12% of your earnings between £8,164 and £45,000. At an income of around £45,000, a person’s income tax rate doubles from 20% to 40%. The National Insurance rate falls from 12% to 2%.
Benefits in kind
Employees can receive benefits in kind in addition to their pay in cash. Such benefits can often include a company car, medical insurance, cheap loans, use of assets and similar.
Most of these benefits are subject to income tax. However, most non-cash benefits are not subject to Class 1 National Insurance. So if you provide £1,000 in cash, an employee may pay £200 in income tax and £120 in national insurance, leaving £680. If you provide £1,000 in benefit, the employee may pay £200 in tax and nothing in national insurance, leaving £800.
The employer will usually have to pay Class 1A National Insurance on such benefits. The rate is the same as the employer’s National Insurance for Class 1. So the cash benefit is to the employee only. The employer only gets a small cashflow advantage as Class 1A (13.8%) is paid later than Class 1.
Some benefits are free of National Insurance and tax. These include weekly childcare vouchers, personal incidental expenses while away on business and partnership shares in an incentive plan. These benefits should be of interest to both employers and employees.
National Insurance is not just a tax, but a contribution towards the state retirement pension.
In order to qualify for a state pension, you must have paid Class 1, 2 or 3 contributions for 30 years to qualify for a full pension. As a working life is now up to 49 years, some can be missing without affecting the pension. However, there have been a number of cases in which people retire and discover that they are not eligible for the state pension which they expected.
Unlike income tax, National Insurance is calculated for an earnings period. This can be for the whole year like income tax but is usually just for a month or however frequently a person is paid.
Sometimes, someone may have different earnings periods. For example, a salesperson may receive a monthly salary, quarterly commission, and an annual bonus. In this case, the earnings period is usually the shortest period. This means that a large bonus in one month could put some of your income into the 2% band, whereas it would be taxed at 12% if spread evenly throughout the year.
A similar effect can be achieved for statutory maternity pay. For the first six weeks, this is paid at 90% of weekly earnings calculated as an average over an eight-week period. If an annual or quarterly bonus is paid in the eight week period, the woman will receive an additional SNP.
Help from SJD Accountancy
National Insurance can often be difficult to understand when you first become a contractor. Your accountant at SJD can help you to understand your responsibilities and assist with your finances.