As the director of a small company, you have a choice when it comes to how you pay yourself. You can either draw a salary, or you can pay yourself in dividends, or opt for some of each. Both options have their own pros and cons, particularly when it comes to tax considerations.
You’d ideally want to make sure that your payment is tax-efficient for both yourself and for the company.
It’s understandable to have questions about this. Such as – what are the benefits of salary vs dividends? How much dividend can I pay myself tax-free? In this blog post, we answer all your questions and more.
First, what is a dividend?
A dividend is a way of sharing a company’s net profit (i.e. profits after paying business expenses and corporation tax) with its shareholders.
Dividend payouts are made in proportion to the shares held by each shareholder. If your company has multiple classes of shares, you may choose to declare different types of dividend, such as an advance payment to holders of preference shares.
As is evident from this definition, a dividend is only payable if the company has made a net profit.
Plus, the company isn’t required to pay its profits as dividends. It may instead choose to retain them and distribute them after some time, depending on what the board of directors deems appropriate.
Limited companies typically have a provision for the dividend payment schedule in their Articles of Association. Usually, it’s once or twice a year. To pay a dividend, there first needs to be a formal directors’ meeting.
Each payment needs to be accompanied by a voucher with the company name, date of payment, and the amount of dividend. The company doesn’t pay any separate tax on dividends, as they’re only issued after having paid corporation tax.
How do directors pay themselves an income from the company?
Typically, company directors don’t make a hard choice when it comes to salary vs dividends. They pay themselves a mix of both, along with some form of pension contribution.
Of course, how you decide to split your income between salary and dividends depends on various factors, such as tax considerations (both for yourself and for the company), how much profit the company has made, and whether you want to opt for any state benefits like state pension or maternity benefits.
Income tax rates of salary vs dividends
Overall, dividends attract lower rates of income tax across each tax bracket, compared to salaries. Let’s see what that looks like:
- Up to £12,570 – no income tax on salary
- Up to £14,570 (includes £12,570 personal allowance plus £2,000 dividend allowance) – no income tax on dividends
- Basic rate for salary (£12,570 to £50,270) – 20%
- Basic rate for dividend (£14,570 to £50,270) – 8.75%
- Higher rate for salary (£50,271 to £125,140) – 40%
- Higher rate for dividend (£50,271 to £150,000) – 33.75%
- Additional rate for salary (£125,141 and up) – 45%
- Additional rate for dividend (£150,001 and up) – 39.35%
The pros and cons of salary vs dividends
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Both salaries and dividends have their upsides and downsides. Splitting your income between the two depends on what considerations you value more than others.
Pros of taking a salary
- You get paid a salary even if the company hasn’t made a profit, just like everyone else on the payroll.
- Salary is an allowable business expense, which reduces the corporation tax bill for your company.
- You can enjoy maternity benefits.
- You can contribute more to your personal pension.
- You add more qualifying years towards state pension.
- You can apply for mortgages and insurance policies more easily.
Cons of taking a salary
- You have to pay National Insurance Contributions (NICs) on a salary that passes the NIC Primary Threshold of £12,570 per year. Plus, the company has to pay employer NIC on an earning above £9,100.
- A salary involves paying a higher rate of income tax than a dividend, especially if you draw a considerable salary.
Pros of taking a dividend
- Dividends have a much lower tax rate than income taxes, as we have outlined above.
- You get a tax-free dividend allowance of £2,000, over and above your annual personal allowance of £12,570. This means you don’t need to pay any income tax until your earnings cross £14,570.
- Neither the company nor you personally have to pay NIC on dividends.
Cons of taking a dividend
- Dividends are only paid after the company has paid out its corporation tax and business expenses. If there’s no money left, you don’t get any payout, which makes your income unpredictable.
- Dividends don’t count as relevant UK earnings in the context of tax relief on the pension contributions you make for yourself.
- If you take out a dividend amount that the company’s profits don’t cover, it assumes the form of a director’s loan that you must later repay.
Salary vs dividends: how to choose?
We always recommend taking a small salary as company director so that you’re guaranteed a certain income every year. One tip to avoid paying NIC on your salary is to set your salary amount between the Lower Earnings Limit (which is £6,396) and the Primary Threshold.
Your salary needs to be at or above the Lower Earnings Limit to build up qualifying years for state pension – this way, you get to keep your pension while avoiding NIC payments.
In addition, if you plan to rely mostly on dividends for your income (and indeed, the tax benefits are considerable if so), we recommend working with an experienced accountant who can help your company set up a process that declares profits and accounts for dividends in good time.
Final words
So are dividends better than salary? From the income tax rates alone, one might be tempted to think so. But the fact is that dividends are contingent on how much profit the company makes in a year, whereas a salary is paid regardless of the company’s profit or loss.
When deciding how to split your income between salary vs dividends, we always recommend working with an accountant.
We at 3E’S Accountants can especially help you be fully cognisant of the tax difference between salary and dividend and what the implications are for both you and the company, so that you can make an optimal choice.
Book a free consultation with us today.
