15 September 2019Money

Contracting vs Permanent

Recently I had to make a decision whether I want to go into contracting or stay as a permanent employee.

Permanent

Here’s how the numbers looked like for me as a permanent employee at the time of making the decision:

+£87,500.00Salary
+£13,637.16Stock options 1
+£3,500.00Employer pension contribution 2
-£22,500.00Income tax 3
-£5,714.64National Insurance tax 4
-£2,727.43Capital Gains tax
=£73,695.09

1£2.07 x 6,588
2£87,500 x 4%
3£37,500 x 20% (base rate) + £37,500 x 40% (higher rate)
4£41,372 x 12% (base rate) + £37,500 x 2% (higher rate)

Contracting

If I go into contracting I could work at a £550/day rate. I would be able to bill 200 days a year (253 in total - 30 days holiday - 23 days looking for contracts. I know I’m being conservative here). I would pay myself a base salary of £12,500, which would draw £464 NI tax. I have about £6,000/year tax deductable expenses. The rest of my income would be taxed at 17% corporation tax leaving me with undistributed profits in the company. I would pay myself £37,500 dividends, which are taxed at 7.5% [link] while at a basic income tax rate (under £50,000). For the remainder of the money I’d have to pay 10% capital gains tax if I draw it down when closing the company (which would enable me to use entrepreneurs relief and a lower capital gains tax rate of 10%).

So here’s how the numbers could look like if I started contracting:

+£110,000.00Contracting income 1
-£464.00National Insurance tax 2
-£15,555.00Corporation tax 3
-£2,625.00Income tax on dividends 4
-£3,844.50Capital Gains tax 5
=£87,511.50

1£550/day x 200 days
2£12,500 - £8,628 (tax free allowance)) x 12% (base rate)
3(£110,000 - £12,500 - £6,000) x 17%
4£37,500 x 7.5% (base rate)
5(£110,000 - £12,500 - £6,000 - £15,555 - £37,500 - £2,625) x 10% (entrepreneurs relief)

Initial comparison

Let’s compare the numbers:

As a permanent employee my take home pay is £73,695.09.
As a contractor my take home pay could be £87,511.50.

That’s a staggering £13,816.41 take home pay difference, which is down to higher taxes and lower income! Seems like contracting is an obvious choice? Not so fast. There are a couple of important things that go for permanent employees that swung my decision.

Stock options in lieu of salary

This option is either not available or less common, much more difficult to arrange for and taxed differently if you are contracting.

Stock options are what keeps permanent roles afloat as they offer potential for higher returns. Depending on the stage of the company, the returns can be multiple times greater than the initial value. And that’s a big thing. There are also risks involved and if you are “bird in hand” type of person, then read no further as contracting offers higher and safer short term (when I say short term, I mean 1-10 years) returns. However, if you are “deer in a forest” type of person then company stock options are worth considering.

I was pleasantly surprised when I was given an opportunity to reduce my salary in lieu of stock options (that’s not always an option by the way)! I’ve opted to go for 20,000 extra shares a year at a current price (£2.07), which reduces my salary to £46,100/year. This means that I will need to pay less tax and I will only need to pay tax at the time I decide to sell my shares.

Here’s how the numbers work out after the change:

+£55,037.16Stock options 1
+£46,100.00Salary
+£1,844.00Employer pension contribution 2
-£11,007.43Capital Gains tax 3
-£6,720.00Income tax 4
-£4,496.64National Insurance tax 5
=£80,757.09

1£2.07 x (20,000 + 6,588)
2£46,100 x 4%
3£55,037.16 x 20%
4(£46,100 - £12,500) x 20%
5£41,372 x 12%

So my initial income decreases slightly but the tax also goes down which increases my take home pay by a whooping £7,062 (£80,757.09 - £73,695.09)! However, and more importantly, this increases my potential for greater returns (and greater losses) in the future.

After taking the stock options into account the decision then becomes £6,754.41+ now (’+’ for the fact that stock options could become 0 income) or greater risks and potentially more money in the future? The answer for me was “I’m in this for some big time!“.

Bonus - self-invested private pensions

Self-invested private pensions (SIPPs in short) are available to both contractors and permanent employees.
You can invest up to £40,000 or your salary (whichever is smaller) tax free into a private pension fund (source).
The money the government pays in pension tax relief and contributions paid in by your employer count towards your yearly allowance (source).

Here’s how the number would look like if I wanted to max out my yearly allowance:

+£30,524.80My contribution
+£7,631.20Government contribution 1
+£1,844.00Employer contribution
=£40,000.00

1£30,524.80 x 25%

So what am I going to do in practice? Out of my net salary after taxes (£34,883.36) I plan to pay £30,000 a year to my pension fund to get an additional £7,500 back from the tax man. I also like round numbers 🙂

So this is how my yearly income looks like after my pension contributions:

+£55,037.16Stock options 1
+£46,100.00Salary
+£7,500.00Government pension contribution 2
+£1,844.00Employer pension contribution 3
-£11,007.43Capital Gains tax 4
-£6,720.00Income tax 5
-£4,496.64National Insurance tax 6
=£88,257.09

1£2.07 x (20,000 + 6,588)
2£30,000 x 25%
3£46,100 x 4%
4£55,037.16 x 20%
5(£46,100 - £12,500) x 20%
6£41,372 x 12%

Important caveats

There are other factors that have influenced my decision but have no numbers attached to them.

My financial position

It’s important to note that I’m sacrificing short-term gains in hopes of gaining more in the long-term. I can only take this gamble because of the financial position that I’m in. In other words, I wouldn’t be comfortable making this decision with a smaller bankroll as the losses would be too great. I am confident that if this doesn’t work out, I’d be able to continue taking these “gambles” to eventually turn to profit.

Control over my destiny

Another important factor is me not being ready to invest the extra income elsewhere. It’s difficult to find a good place to invest £80,000 if you haven’t done this before (which is the case for me). I feel that by investing in myself and the team around me I have more control over the money as I can impact the direction we are taking. My preference is to invest in something I have influence in over something that is out of my control, e.g. shares of other companies.

Conclusion

I have chosen to stay as a permanent employee and double down on myself and people around me. I was only able to this because I was lucky enough to have the financial security that allows me to play for the big money. If I didn’t have the savings I do have then my decision probably would have been different.