For many small business owners or directors, the first few years of trading are characterised by hard work and long hours, and so it is quite understandable that, in return, you would want to be remunerated in the most tax-efficient way possible.
There are three main ways in which a director can draw income from a limited company:
- Pension Contributions
Once a limited company starts to make a profit, most company directors will pay themselves through a combination of salary and dividends, supplemented by pension contributions. However, the exact salary/dividend split will be determined by a range of factors, including the company’s profits, your own personal tax plans, and the importance you place on reducing the company’s tax burden.
Taking a Salary
Many company directors opt to take a salary via Pay as You Earn (PAYE). Not only will this give you dependable, regular income, but you can take a salary regardless of whether your business is making a profit. Securing personal loans and mortgages is far easier when you can demonstrate a salaried income, and you will still be eligible for state aid such as maternity benefits. From the company’s perspective, the biggest advantage is that your salary will be classed as an overhead and deducted from profits – reducing the annual corporation tax charge.
However, in terms of your personal tax position, taking a salary has two major disadvantages when compared to dividends. Firstly, dividends attract a lower income tax rate. The tax rate on dividends is currently 7.5% for a basic rate tax payer (after the £2,000 dividend allowance), compared to 20% payable on PAYE salaries (once the personal allowance has been reached). Salaries also attract National Insurance contributions (NICs), which are payable by both the company and the director.
The best way to tackle this tax inefficiency is to take some of your income by way of a small salary which makes use of your personal tax allowance. In this way, not only do you minimise your tax liability, but you retain the benefits of taking a salary and protect your future entitlement to state pension and other benefits.
The personal allowance for the tax year 2020/21 is £12,500, which means that tax is not due on income received up to £12,500 (i.e., a salary of £1,041.67 per month). However, while income tax is not payable, once the NIC Primary Threshold of £9,500 is reached, deductions will be made for national insurance contributions. As a company director, you may wish to consider a salary of less than £9,500 to avoid paying employee NICs, although we often recommend a salary of at least £6,240 (the Lower Earnings Limit) to protect your entitlement to state pension.
From the company’s perspective, paying salaries to directors reduces the corporation tax liability, but once the salary exceeds £8,788 (the Secondary Threshold), employers’ NICs will apply at 13.8%, representing an additional cost to the business.
Taking Income Through Dividends
Dividends typically present the most tax-efficient way for a company director to extract profits from their business. However, for dividends to be permissible, the following conditions must be met:
- The company must have sufficient retained profits to cover the dividend. A dividend is defined as a share of company profits – if there are no profits, there is no share
- The dividend must be paid in proportion to shareholdings
- All dividends must be properly declared.
When compared to salaries, taking an income from dividends is significantly more tax efficient, given that they are subject to a much lower rate of tax and do not attract employee nor employer NICs. The main disadvantage is that dividends cannot be used to reduce the company’s corporation tax liability, as they are taken from post-tax profits.
In the tax year 2020/21, the tax-free dividend allowance is £2,000 – this is in addition to your personal allowance of £12,500. So, if you were to take a salary of £12,500 and a dividend of £2,000, your tax liability would be zero!
Once the dividend allowance has been used, basic rate taxpayers will pay 7.5% tax on dividends, while higher rate taxpayers will pay 32.5%. The corresponding income tax rates are 20% and 40% – considerably higher than the related dividend tax rate.
Salary vs Dividends Calculator
To calculate the tax payable on a salary vs a combination of salary and dividends, try this Dividend vs Salary Calculator.
As an example, if a company director were to take an income of £50,000, the total take home pay and tax liability would be as follows:
Option 1: £50,000 taken as salary only
- Take home pay: £34,244
- Tax liability: £15,756
Option 2: Salary taken up to the personal allowance. Remainder paid in dividends
- Take home pay: £40,005
- Tax liability: £9,995
As you can see from this example, the difference in take home pay between a ‘salary only’ approach to extracting income and a combination of salary and dividends is £5,761, demonstrating the tax efficiencies resulting from utilising dividends.
A third way to receive tax-efficient remuneration is via pension contributions, although it should be remembered that these contributions cannot be accessed until the age of 55 and so will not provide a source of income now.
The main benefit of employer pension contributions is that they are not accounted for in your personal tax calculation but are an allowable business expense and so will reduce the company’s corporation tax bill. Furthermore, they are not subject to employer NICs, and the only limit to contributions is £40,000 per year, or 100% of salaried earnings (whichever is lower). For a company director receiving a salary of the personal allowance limit of £12,500, the company can make tax-free pension contributions of £12,500, reducing their profits by the same for corporation tax calculation purposes.
Blue Roof Accountants: A Bespoke Service Tailored to Your Specific Needs
At Blue Roof Accountants, we give small business owners proactive, pragmatic advice on how to manage their company finances and reduce their tax burden. From accounts preparation and corporation tax calculation, to personal tax planning and management consultancy, we work with company directors, sole traders, and entrepreneurs throughout Dorset to help them achieve maximum financial benefit from their business.
If you need straightforward advice from our experienced, friendly team, contact us today on 01202 532288.