Salary or Dividends, Which is Better?

Salary or Dividends, Which is Better?

When sole proprietors or partners form a limited company, it becomes a legal entity in the eyes of the law. This means that all finances legally belong to the business; directors cannot simply withdraw money from the business like their own personal bank accounts.

So, that begs the question, what is the most tax-efficient way for company directors to take an income – being paid a salary or taking dividends? Well, the short answer is, it depends. 

Most directors of limited companies pay themselves in some combination of salary and dividends. To help you decide the right combination for you, here are some factors to consider:  `

• The company’s profits
• Minimizing your personal tax deductions 
• Minimizing your corporation tax deductions 
• Personal allowances and benefits (e.g. maternity benefits, pensions) 

Salary, or Not to Salary?

As a director, it’s a good idea to take at least a small salary as it provides several benefits including enabling you to:

• Qualify for state pension
• Make higher personal pension contributions
• Retain maternity benefits
• Apply for financial products and loans more easily (e.g. mortgages and insurance policies)
• Minimize the company’s corporation tax payments 
• Take a salary even if the business isn’t generating any profits

On the other hand, there are also potential disadvantages to taking a salary, such as:

• Salary payments make both you and the company liable for national insurance contributions (NICs)
• Attracting a higher rate of income tax than dividends

Deciding How Much Salary to Take

The personal salary allowance currently sits at £12,570 in the 2022/23 tax year*. That means you are only liable to pay taxes on salary earnings over £12,570. However, you will have to pay NICs if your income passes the primary threshold which is currently £9,880*.

To qualify for (and to continue to) contribute to your state pension, your salary must be at or over the NIC lower earnings limit. Setting a salary between the NIC lower earning limit of £6,396 and £9,880 (the primary threshold), would enable you to retain your state pension but avoid paying NICs.

 

Divvying Up Dividends

A dividend is simply a share of the company’s profits. If the company is not profitable, then no dividends can be paid. Many directors choose to take the majority of their income in the form of dividends, as this is usually more tax-efficient.

Dividends can be paid to directors and other shareholders, according to the proportion of shares that they hold. Directors can decide to pay all the company’s profits as dividends, a portion of the profits, or none at all, and rather retain profits over a number of years and distribute them as the board sees fit.

A couple of distinct advantages of dividend payments are:

• Dividends attract lower rates of income tax than salary payments
• No NICs are payable on dividends (neither the employers nor the employees)

Taking the majority of your income as dividends can significantly reduce the income tax you are liable to pay.

Between the tax-free dividend allowance (£2,000) and the personal allowance (£12,570 in the 2022/23 tax year*), you can earn up to £14,570 before paying any income tax at all.

 

Minimizing Tax Payments, Maximizing Your Earnings

Clearly, a number of factors affect what may be the best salary to dividend ‘mix’ for your personal circumstances. By way of example, Olamide takes a salary of £9,880 to keep below the NIC threshold and avoid paying income tax. She takes a further £30,000 in the form of a dividend payment. Her earnings would look like this:

Total income = £39,880

Personal tax free allowance = £12,570 (not taxable)

Tax-free dividend allowance = £2,000 (not taxable)

This means that of Olamide’s total £39,880 income, only £25,310 is taxable.

When this is taxed at the dividend basic rate of an income tax rate of just 8.75%, Olamide’s total income tax bill for the year is only £2,214.

Conversely, if Jane had taken the entire £39,880 as a salary payment, her income tax bill would have been £5,462. Additionally, she would have been required to pay £3,975 in NICs.

In other words, the optimal combination of salary to dividends would enable Jane to save over £7,000 in that year alone.

Also of note is the company’s liability employer NICs on Olamide’s salary (£4,632), although to some degree this would be offset by the lower corporation tax rate.

 

Dividend Downfalls

Given the significant potential tax savings, taking your income mostly in the form of dividends may seem like the obvious choice. However, there are additional considerations:

• Dividends can only be paid out of profits, so if there are no profits, there are no dividend payments
• Dividends are also only paid after corporation tax has been deducted
• Dividends don’t count as ‘relevant UK earnings for the purposes of tax relief on any pension contributions that you make 

Whether you plan to rely on dividends for some or most of your income, or you want help deciding which method of payment is most tax-efficient for both you and your company, 121 Company Formation offers full accounting services for small businesses like yours.

Our expert team is always ready to assist in finding the most tax-efficient ways for you to pay yourself from your company.

 

About 121 Company Formation

121 Company Formation is one of the UK’s leading online company formation agents. We have helped over 50,000 entrepreneurs register a company in the UK. We offer the most comprehensive range of services including company formation packages that start at just £15.95, administrative, accounting, and bookkeeping services to support you and your business before, during, and after the incorporation process.