Salary VS Dividend

SALARY VS DIVIDEND

Taking a salary from your company

As a director, it’s a good idea to take at least a small salary. This mean putting yourself on your company’s payroll. There are several benefits of taking part of your income as salary.

The benefits of taking a salary

You build up qualifying years towards your state pension
You can make higher personal pension contributions
You can retain maternity benefits
It can be easier to apply for things like mortgages and insurance policies such as critical illness cover
You reduce the amount of corporation tax that your company pays (as salary is an allowable business expense)
You can take a salary even if your business makes no profit

There are however several drawbacks to taking a salary, particularly a large one.

The drawbacks of taking a salary

Taking a salary means that both you and the company have to pay National Insurance contributions (NICs)
A salary also attracts higher rates of income tax than a dividend does

Deciding how much salary to take

You don’t pay income tax on your earnings until pass the personal allowance (currently £12,570 in the 2022/23 tax year). However, you will have to pay NICs if your income passes the NIC Primary Threshold (currently £12,570). In addition, employer NICs become payable on any employee earnings above £9,100.

Note that in order to build up qualifying years for the state pension, your salary must be at or over the NIC Lower Earnings Limit (currently £6,396). Some directors therefore set their salaries between the Lower Earnings Limit and the Primary Threshold, so as to keep their state pension but avoid paying NICs.

Taking dividends as income

Many directors choose to take the majority of their income in the form of dividends, as this is usually more tax-efficient.

What are dividends?

A dividend is simply a share of the company’s profits. Profit is what is left over after the company has settled all its liabilities, including taxes. If there is no profit, then no dividends can be paid.

Dividends can be paid to directors and other shareholders, according to the proportion of shares that they hold. There is no requirement to pay all the profits as dividends, or even any of them. A company can retain profits over a number of years and distribute them as the board decides.

The benefits of taking dividends

Dividends attract lower rates of income tax than salary
No NICs are payable on dividends (neither employer’s nor employee’s)

By taking most of your income in the form of dividends, you can significantly reduce your income tax bill.

Your dividend allowance

You have a tax-free dividend allowance, which is in addition to your personal allowance. In the 2022/23 tax year this allowance is £2,000. This means that you can earn up to £14,570 before paying any income tax at all.

Income tax rates on dividends

Dividends attract a much lower rate of income tax than salary does. There is also a slightly greater tax-free allowance when you are paid in dividends. Here is a comparison table:

Salary Vs Dividend Tax Rate

Example:Jane takes a salary of £9,100 (keeping below the threshold for paying both employer and employee NICs and income tax) and takes a further £30,000 in the form of a dividend. Her total income is now £39,100. She has a tax-free personal allowance of £12,570 in 2019/20, leaving £26,530. Her dividend allowance means the first £2,000 of dividends are tax-free, leaving £24,530 that is taxable.This £24,530 is taxed at the dividend basic rate of income tax, which is just 8.75 per cent. So Jane’s income tax bill for the year will be £2,146.38.If Jane had taken the whole £39,100 as salary, then her income tax bill would have been 20 per cent of £26,530 which is £5,306. She would also have to pay over £3,603 in employee NICs.By taking her income in a combination of a low salary plus dividends, Jane has saved almost £7,000 in that year.Also note that the company would have to pay employer NICs on her salary, coming in at £4,515. However, this will be offset to some extent by lower corporation tax.The drawbacks of taking dividendsAlthough taking your income mostly in the form of dividends may seem like a no-brainer, there are certain limitations and pitfalls to watch out for.

Dividends can only be paid out of profits
Relying too much on dividends can make your income unpredictable
Dividends are paid after corporation tax has been deducted (unlike salary, which is a tax deductible expense)
If you accidentally take a dividend that is not covered by profits, you will have taken out a director’s loan which must be repaid
Dividends don’t count as ‘relevant UK earnings’ for the purposes of tax relief on pension contributions that you make yourself (see below)

If you plan to rely on dividends for some or most of your income, then ensure you have a rigorous accounting function in place to declare profits and account for dividends in good time. Your accountant can also help you work out which method of payment is most tax-efficient for both yourself and your company – as this can be quite convoluted.