This guide talks about the impact IR35 will have on your take-home pay. How much will IR35 cost you? Should you go Inside IR35/Umbrella or Perm?
It’s now time to talk numbers. The math will hopefully help you decide whether IR35 has made contracting worth continuing. The answer, as usual, is: it depends! Before we dive in, first some definitions. What do we mean by Outside IR35, Inside and Perm:
Outside IR35: The pre-2020 contracting landscape. You operate as a limited company that pays corporation tax and personal income tax. You have the freedom to choose your taxes based on how much you want to withdraw as salary/dividends from your company. Also, business expenses can be claimed.
Inside IR35 / Umbrella: You still operate as a contractor through your limited company or through an umbrella. The take-home pay amounts between inside IR35 and umbrella are very similar. You are taxed more than a permanent employee. That’s because you have to pay both yours and the Employer’s National insurance.
You’re not paid while drinking Pina Coladas on the beach or when sick (except a small amount of Statutory pay).
Your gross pay is usually higher than a perm to compensate for these plus all other minuses that come with contracting, like void periods, short notice period, accounting, DIY pension etc. You don’t get to choose when to withdraw your profits, as everything is taxed at source and you must take all income home now.
Permanent employee (perm): The majority of the workforce belongs here. The usual employee of a company, who belongs to the company payroll, has a salary that lands in your bank account each month no matter what. Entitled to holidays, sickness pay, and potentially other benefits such as pension, training and mandatory performance reviews.
How much will IR35 cost me Inside IR35 or Umbrella?
This is the most common question. People switching from Outside IR35 to Inside or Umbrella want to know how much income they will lose.
For starters, we assume that the Outside IR35 contractor takes all income home and leaves nothing in the company.
Taking all income out is not the most tax-efficient way to deal with your company money. But it’s a good baseline so let’s start with that. The following graph shows the take-home pay Outside IR35 compared to Inside IR35/Umbrella at the same rate.
The higher the rate the more it will cost you to transition from outside IR35 to inside IR35. But it’s not that bad. (hint: it gets worse).
So in most cases, a contractor will lose anywhere between 15% to 20% of their take-home income. Here’s a graph, showing the percentage difference for the given rates.
Punchline: For tax-inefficient contractors who take all money home, the difference between Outside IR35 -> Inside IR35 (or Umbrella) is between 15-20%.
What if you switch to perm, instead? Let’s see how an Outside IR35 compares to the same gross income taken as a perm employee.
Cost of moving from Outside IR35 (All Out) to Perm
But a few people I know have abandoned contracting altogether and want to switch to perm. What would the impact be if we take the same gross income as a perm?
Here’s the take-home pay when taken as an Outside IR35 contractor vs the equivalent gross pay as a perm employee. I’ve used the salary calculator (link) to calculate the take-home pay of all perm salaries.
As you can see, going perm doesn’t make much of a difference. On £600 per day, for which the equivalent annual gross is £132,000, the difference is just £6,000 per year.
However, here’s the catch:
It is really hard to achieve the same gross income as a perm. Here is a table outlining the equivalent gross amount of a daily rate when charged annually (44 working weeks. 5w hols, 8d bank hols, 7d sick/void):
Do you see the problem? In my experience, a contractor on £300/day will find it really hard to find a job at £66,000. Similarly, one who earns £600/day won’t easily find a £132,000 perm salary, even if you account for things like pension and bonus.
And it makes sense from a risk point of view. As we explained in Part I of this IR35 series, as a contractor your client doesn’t provide months of leave notice, job security or any perks. You provide a service at a cost. You are a Capital Expenditure (CapEx budget).
As a perm, the company makes commitments to you which is why the equivalent gross pay is unrealistic. I don’t know exactly what the equivalent “discount” we need to apply here when switching from Outside IR35 to Perm. But I do know there is one. So the percentage difference is higher than the table above suggests – to some extent.
The difference is BIG when the contractor is tax-efficient
The gap between Outside IR35 and all the other options widens further if you’re a tax-efficient contractor.
I’m sure you know a lot of people who don’t take all the money home.
Most contractors I know will at least take advantage of the minimum salary/dividends payout. So they all withdraw a minimum salary and dividends up to the point that doesn’t cross the higher taxpayer threshold (£50,000 as of 2020).
I think we can all agree this is a good tax strategy assuming you have no other (unsheltered) income outside your LTD affairs. Why take more £50,000 a year and pay higher taxes if you can just leave the money in the company and just pay corporation tax? Assuming, of course, you can live on this amount.
To the extreme end of this spectrum, there are people like myself who invest their company money. I consider my LTD money as “take-home” because it can provide income for years to come when invested. Others just leave it in there in cash and at some point, they claim “Entrepreneur’s Relief” (if this is not scrapped soon). This means they will only pay 10% tax to take it out of the company.
This all means the take-home pay for Outside IR35 contractors can be different from person to person despite having the same daily rate.
Putting it all together we have the following groups:
- All Out: Some other people say I want all my capital in my pocket, therefore I’m happy to pay the extra dividend tax to do that. This means I’ll have to apply a 32.5% dividend tax on the money before it becomes “take-home”. All-out approach
- Leave Surplus In strategy: Some, like me, consider the LTD surplus cash as “take-home” pay. Since you can invest the company money, the income/dividends will keep coming and I don’t need to (ever?) withdraw this surplus. So for the purposes of providing me income, the money is effectively take-home although it still belongs to the company. This is mathematically the most tax-efficient way.
- Entrepreneurs Relief approach: Some others take an accumulative approach but with ER in mind. They say, I will only withdraw a minimum salary and dividends as everybody else does and I will leave the rest of the money in the company. When the sum is big enough, I will close the company down and claim Entrepreneur’s Relief by paying only 10% tax to make the money mine. I will call this approach the ER approach.
So for an Outside IR35 contractor who takes a £50,000 take-home and leaves the surplus in the company (on 10% tax, Entrepreneurs Relief) here is the difference in take-home:
That’s a BIG difference. So if you leave some money in the company, moving from Outside IR35 to inside IR35 is going to cost you 30% loss of income on £650 per day. It’s “just” 15% on £200 per day but can go up to 33% loss on £1000 per day.
A bit depressing if you’re an Outside IR35 on a high rate. The data don’t lie!
Putting it all together: Outside IR35 vs Inside IR35 & Umbrella vs Perm
If we put all possible options in one single graph, it looks like this:
And that’s all on the same gross pay!!!
So when people ask me whether converting from contracting to perm has a difference, the answer is: It depends on how well you handle your taxes. If you’re wise with taxes, then it makes a massive difference. As you can see, an Outside IR35 contractor on £500 per day, who Leaves Surplus In goes from £87,000 down to £70,000 (perm) or £62,400 (Umbrella). That’s a 30% drop in take-home income!
If you want to have a detailed look at the exact numbers, here’s the full table:
Even if you’re not working exactly 44 weeks and make the same assumptions as I do, the above table gives you a good indication. Here is a link to my spreadsheet which I used to calculate all the Outside IR35 take-home options. Use File -> Make a copy to edit the file, please do not request access to edit mine.
You may be wondering:
How can I improve my take-home pay if I cannot continue contracting Outside IR35?
There are a few things you can do to improve your take-home pay.
- Negotiate a rate increase
- Contribute to your pension
Negotiating a rate increase can work sometimes but it’s a bit futile. If everyone is running around like a headless chicken, why would companies offer more? It’s a question of supply and demand really because I’m sure companies still need some flexible workforce to scale up and down quickly.
So we shall wait and see who needs who more 🙂
Contributing to your pension is a sure win from a tax point of view and makes the transition much smoother. That’s because your pension contributions are income-tax-free, NI-free and corporation tax-free. In the next article we are going to answer the following questions:
- How can I increase my take-home pay inside IR35, Umbrella or Perm?
- How much do I need to increase my rate inside IR35 to match my Outside IR35 take-home?
- A contractor works approximately the same weeks as a perm employee. Takes 5 weeks holidays, 8 days bank holidays, 7 days sickness/void periods between contracts. Total: 44 working weeks.
- All calculations were done for the Financial tax year 2019/20
- No pension was added to either perm or contract. It can save both perm and contractors a lot of tax. Pension deserves its own chapter, which is why we’re going to have another article just on how to use pensions to extract more out of your salary.
- Perm calculations include ALL benefits, bonus, overtime etc except pension.
- Used my Outside IR35 Contractor calculator (Google Sheet) to calculate all take home styles
- Inside IR35 calculations provided by Contractor Calculator – link
- Salary (perm) calculations by The Salary Calculator – link