Salary vs dividends Taking income from your company

Salary vs dividends: Taking income from your company

When you run a business how do you pay yourself?

Once you have a ltd company you are legally required to run a dedicated bank account for that company so any money you transfer yourself needs to be considered for tax purposes.

There are generally two ways to pay yourself either via dividends or salary. The main difference between the two is the tax rates. The basic pay rate for income tax for tax year 2021 is between £12,571 to £50,270 (as the first £12,570 is tax free) the income tax rate for salaries is 20% but the dividend tax rate is only 7.5%

But there are several things to consider over just the tax rate when making your decision, including how many shareholders, available profits, other income streams etc which we will discuss in this blog.

Taking a salary from your company

Taking a salary from your company means you are effectively paying yourself a wage, this is the same as if you were employed by a 3rd party but setting what to pay is often where the issue arises.

As mentioned above the tax free allowance of £12,570 is tax free, therefore if you pay yourself this amount in 2021 as a salary you will pay no income tax, however you will pay National insurance if your salary passes the NIC primary threshold of £9,568 in 20/21.

NOTE: To ensure you build up enough qualifying years for the state pensions, you need to pay a salary that meets at least the Lower Earnings limit (£6,240) for this tax year.

So some directors often choose to pay themselves between the Lower Level and Primary NIC thresholds to meet qualifying years but avoid paying NIC’s

Let’s look at some 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 retain maternity benefits
  • Salary is a taxable expense and reduces your corporation tax
  • Salary can be paid even if you make a loss (a common issue with dividends)
  • It can be easier to apply for mortgages etc paying a set wage

However, there are also some disadvantages to taking a salary,

The drawbacks of taking a salary

  • Taking a salary can be more expensive if you reach NIC thresholds as you have to make employee and employer contributions
  • Salaries are subject to a higher level of income tax

Taking dividends as income

Most directors choose take the majority of their income as dividends rather than salary since dividends are more tax-efficient, however we saw with the issue around COVID in 2020 where  the government offered Furlough and this did not cover payments made in dividends. There was no real set reason behind this decision other than potentially support was not offered where lover level  of income tax was paid previously.

Since then it has changed mindsets of some directors to consider whether paying the lowest level of income tax is the most important decision!

What are dividends?

In the simplest form Dividends are a share of the company’s retained profit. This is profit available after corporation tax (which is often forgotten when paying dividends as corp tax is not automatically calculated day to day), therefore common issues arise where directors use their bank balance and P&L only not considering future tax liabilities reducing their available profit.

Dividends can be paid to directors and other shareholders, according to the proportion of shares that they hold therefore distribution can become more complex if you have more investors.

There is no mandatory requirement to pay dividends, profits can be retained over a number of years as often businesses will re-invest cash before distributing dividends.

The benefits of taking dividends

  • Dividends attract a lower rate of income tax than a salary
  • No NIC’s are payable on any dividends
  • Dividends offer an additional tax free allowance of £2k for tax year 2021.

The drawbacks of taking dividends

Although in principle it could seem that taking dividends is the most appealing option, there are some drawbacks to consider

  • Dividends can only be paid if there is enough retained profit
  • If there is more than one shareholder, all dividends have to be distributed equally based on the share proportion.
  • It can be difficult to track and make sure you have enough profit across your financial year as retained profit is after corporation tax
  • Dividends are not a taxable expense so will not reduce your corporation tax
  • If you pay yourself more dividends than available profit it is classed as an overdrawn directors loan, which can attract a higher tax rate of 32.5% at your year end.
  • Dividends do not contribute as earnings towards the pension thresholds

Frequently Asked Questions

What is the tax implication of taking a salary?

Salaries are subject to higher income tax than dividends depending on the value you pay yourself. The table below shows a basic example of tax rates.

2021/22 RATESBASIC RATEHIGHER RATEADDITIONAL RATE
Tax thresholds income tax£12,571 – £50,270£50,271 – £150,000Over £150,000
Tax rates20%40%45%
Dividend rates7.5%32.5%38.1%

So let’s look at an example

Dave is a sole director/shareholder of his ltd company and he has no other income streams.

Dave takes a basic salary of £9,000 this is below the NIC and income tax threshold (so no income taxes to pay)

Dave also then pay’s himself additional £30,000 in dividends

Dave has a total income of £39,000 which falls within the basic rate tax bracket.

Dave has a tax free income tax personal allowance of £12,570 and an additional dividend allowance of £2,000, therefore a combined personal allowance of £14,570

Dave has used £9,000 of his £14,570, leaving him £5,570 to allocate towards his dividends which means he will pay tax at 7.5% of £24,430 therefore a tax bill of £1,832.25

BUT remember Dave needs enough retained profit to cover his dividends of £30,000 therefore it would be important for Dave to track his profit across the months he pays himself to keep track of this.

If Dave had taken the whole £39,000 as salary he would only receive the income tax allowance of £12,570, therefore he would pay 20% income tax on £26,430, calculating a tax bill of £5,286. Dave would also have NIC’s to pay as the pay is above the NIC threshold.

So as you can see the income tax on dividends is more tax effective but there is no a one size fits all and our bookkeeping services support directors to track their profits and balance sheets across their financial year to ensure dividends is the best method for them.

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