Salary vs Dividends: The Most Tax-Efficient Way to Pay Yourself As a Business Owner

As a company director or small business owner in the UK, one of the most critical financial decisions you'll make is how to pay yourself. The structure of your remuneration—whether you choose to pay yourself a dividend, take a salary, or use a combination of both—can significantly impact your tax liability and overall financial well-being. Understanding the intricacies of these options is key to optimising your income, minimising taxes, and ensuring the long-term success of your business.

In this blog post, we'll explore the benefits and drawbacks of paying in dividends versus taking a salary, and provide actionable insights on how to structure your compensation in the most tax-efficient way. We'll also explain why working with a financial adviser can be invaluable in navigating these decisions.

1. Understanding Salary vs Dividends: The Basics

Before diving into tax strategies, it’s essential to understand the basic differences between taking a salary and paying yourself in dividends.

Salary: As a director of your company, you can pay yourself a salary just like any other employee. This salary is subject to income tax and National Insurance Contributions (NICs) and is deductible as a business expense, reducing your company’s taxable profits. This method is straightforward but often comes with higher tax liabilities compared to dividends.

Dividends: Dividends are payments made to shareholders from the company’s after-tax profits. Unlike a salary, dividends are not subject to NICs but are subject to dividend tax UK, which varies based on your personal income tax bracket. It's important to note that to pay yourself a dividend, you must be a shareholder of the company. For those wondering, "Can a director take dividends if not a shareholder?" the answer is no—only shareholders can receive dividends.

2. The Tax Implications of Salary

Taking a salary comes with several tax implications that you need to consider:

Income Tax: Your salary is subject to income tax at your marginal rate. In the 2023/24 tax year, the rates are 20% for income up to £50,270, 40% for income between £50,271 and £125,140, and 45% for income over £125,140.

National Insurance Contributions (NICs): Both employee and employer NICs apply to salaries. For 2023/24, the employee NIC rate is 12% on earnings between £12,570 and £50,270, and 2% on earnings above £50,270. Employers also pay NICs at 13.8% on salaries above £9,100.

Example: If you take a salary of £60,000, you would pay income tax of £7,540 on the first £50,270 (20%) and £3,892 on the remaining £9,730 (40%).

In addition, you would pay £4,635 in employee NICs (£50,270 x 12% + £9,730 x 2%), and your company would pay £6,996 in employer NICs (£60,000 - £9,100 x 13.8%).

Total Tax Cost: £23,063 (including both income tax and NICs).

3. The Tax Implications of Dividends

Dividends are treated differently from salary in terms of tax:

Dividend Tax Rates: For the 2023/24 tax year, the dividend tax UK rates are 8.75% for basic-rate taxpayers, 33.75% for higher-rate taxpayers, and 39.35% for additional-rate taxpayers. There’s also a tax-free dividend allowance of £1,000.

No NICs: Unlike salary, dividends are not subject to NICs, making them potentially more tax-efficient.

Example: If you receive dividends of £60,000, and you’re a higher-rate taxpayer, you would pay 33.75% on £59,000 (£60,000 - £1,000), resulting in a tax liability of £19,912.

Total Tax Cost: £19,912.

4. Salary vs Dividends: A Comparative Analysis

When comparing salary and dividends, dividends generally offer a lower tax liability due to the absence of NICs. However, the choice between salary versus dividends isn’t as simple as choosing the option with the lowest tax.

Key Considerations:

• Pension Contributions: Pension contributions are often calculated based on salary. A lower salary could reduce your ability to make tax-efficient pension contributions.
• State Pension and Benefits: Your entitlement to the state pension and certain benefits depends on your NIC contributions. A low salary might affect your NIC record and future benefits.
• Business Profitability: Dividends can only be paid from profits, meaning if your company is not profitable, you might not be able to take dividends.
• Cash Flow Management: Dividends can be more flexible, allowing you to take income based on the company’s performance, whereas a salary is a fixed expense.

5. Optimising Your Income: A Balanced Approach

When deciding how to pay yourself as a limited company owner, combining salary and dividends can be the most tax-efficient strategy. This approach leverages the tax-free allowances and lower tax rates available for dividends while ensuring you qualify for state benefits through a minimal salary.

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Why the Optimal Mix is Usually Better

• Utilising the Tax-Free Allowance: The first £12,570 of income is tax-free when taken as salary, reducing the amount subject to dividend tax UK.
• Lower Dividend Tax Rates: The remaining income is taxed at dividend tax UK rates, which are generally lower than income tax rates when combined with the tax-free salary portion.
• National Insurance Contributions: By keeping the salary at or below the NIC threshold, you avoid paying NICs while still contributing enough to qualify for state benefits, including the state pension.

Key Observations:

• Income Levels Below £150,000: The optimal mix generally results in a lower or equivalent total tax paid compared to taking the entire amount as dividends. This is due to the combination of the personal allowance for the salary portion and the lower tax rate on dividends.
• Income Levels Above £150,000: As income increases, the optimal mix still provides a tax advantage by utilising the tax-free allowance on the salary and applying lower dividend tax UK rates on the remainder.

6. Advanced Tax Planning: Leveraging Pensions and Other Tax-Efficient Strategies

Beyond salary and dividends, there are other strategies that can enhance your tax efficiency:

• Pension Contributions: By contributing to a pension, you can reduce your corporation tax bill and build a tax-efficient retirement fund. Contributions are deductible from your company’s profits, reducing the corporation tax liability.
• Spousal Allowances: If your spouse is in a lower tax bracket, you could transfer some of your shares to them, allowing dividends to be taxed at a lower rate.
• Use of Director’s Loans: You can lend money to your company via a director’s loan, which can then be repaid without incurring tax, provided the loan is repaid within nine months of the end of the accounting period.

Example: Suppose you contribute £40,000 to your pension. This would reduce your company’s taxable profits by £40,000, saving you £7,600 in corporation tax (assuming a 19% rate).

Result: By combining salary, dividends, and pension contributions, you could significantly reduce your overall tax liability while still paying in dividends effectively.

7. Why Work with a Financial Adviser?

The decision of how to pay yourself as a business owner involves a complex interplay of tax laws, personal financial goals, and business needs. A financial adviser can help you navigate these complexities, ensuring you make the most tax-efficient decisions that align with your long-term objectives.

Benefits of Working with a Financial Adviser:

• Tailored Advice: A financial adviser can assess your specific situation, considering factors like your business’s profitability, your personal financial goals, and your retirement plans. They can help you determine the best balance between salary versus dividends for your unique circumstances.
• Tax Optimisation: Advisers stay up-to-date with the latest tax laws and can help you implement strategies that minimise your tax liability. For instance, they can assist in using a dividend vs salary calculator or a limited company vs PAYE calculator to find the optimal mix.
• Comprehensive Planning: Beyond just salary and dividends, an adviser can help you with pension planning, inheritance tax planning, and investment strategies.

Example: Imagine you’re a company director with a growing business and multiple income streams. A financial adviser could help you structure your compensation, plan for retirement, and even consider exit strategies for the future, all while minimising your tax burden.

Result: By working with a financial adviser, you can confidently make decisions that optimise your income, reduce taxes, and support the long-term success of your business.

Conclusion

Optimising the balance between salary vs dividends is one of the most effective ways for entrepreneurs and small business owners in the UK to minimise tax liabilities and maximise take-home pay. However, the complexities of tax laws and the unique needs of each business mean that there’s no one-size-fits-all solution.

Using tools like a dividend vs salary calculator or a tax calculator for salary and dividends can provide insights, but working with a financial adviser can offer personalised guidance. Whether you are focusing on how to pay yourself in dividends, exploring whether to choose a dividend or salary, or using a limited company vs PAYE calculator, the right strategies can lead to significant tax savings.

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