Dividends vs Salary: Which is the better choice for company directors?
Dividends vs Salary is a common question we get from company directors and limited companies. As a business owner, your business finances and personal finances need to remain separate. Although it may seem possible, you can’t simply dip into your business’s earnings whenever you please, especially when there are other directors and shareholders involved. When you have a limited company of your own, there are two main ways in which you can pay yourself and receive money from your company, namely through a salary or through dividends.
There comes a time in many freelancers’ lives where they make the move over to a limited company, mostly to avoid the heavy tax associated with freelancing. But it is very important that the difference between dividends and salary is fully understood when starting your journey as a limited company. This way, you can maximise your income, minimise your tax, and choose a method of receiving income that works for you. Apart from new company owners, there are also many directors that have been involved in their companies for years who have been making simple mistakes when it comes to making use of salaries and dividends most efficiently, thus probably causing them to lose out on a significant income.
In this article we have a look at the major differences between salaries and dividends, their definitions, as well as their individual tax implications so that you can make an informed decision.
What are dividends?
Dividends are the company profits that are given out to shareholders. When a company makes a profit, they’re able to distribute a portion of this profit to various directors and shareholders. Any part of the profit that is not taken out as dividends is re-invested into the company. If a company does not make a profit, it is not possible to give out dividends to any party, no matter what stake they hold in the company.
What can be described as a salary?
Most people have a good understanding of how salaries work. As the owner of a limited company, you are entitled to pay yourself a fixed monthly salary through the HMRC’s PAYE system. If you want to do this, you’ll need to be registered with the HMRC as an employer. You’ll also need to understand the limitations involved with paying yourself a monthly salary.
Making use of dividends
The reason why many business owners lean towards paying themselves in dividends is because dividends offer you a very tax-efficient solution that is favourable when compared to the tax put onto salaries. Dividends are usually used in conjunction with a salary, with company owners paying salaries just under certain tax brackets and NIC thresholds and then extracting additional funds through dividends.
This sounds like a fairly straightforward solution, but it gets complicated as there are certain criteria that need to be met when paying yourself through dividends. In order to pay yourself through dividends, you’ll need to have enough retained profits in order to cover the dividend amount you wish to pay. You’ll also need to declare the dividend properly and ensure that it is proportionate to shareholdings.
Another reason why people prefer dividends to salaries is because dividends do not attract NIC, as well as the fact that dividends are taxed at a lower rate than salaries. There is also a bracket for tax-free dividend allowances, which is any amount up to £2,000.
What you should keep in mind is that you are only able to take dividends from your post-tax profit. So the amount available to you may have already incurred heavy deductions in the form of corporation tax.
In summary, it is a good idea to make use of both dividends and salaries when extracting money from your business, but it may only be possible to start making use of dividends when your business starts making a substantial profit. If your business is profiting large amounts each year, you’ll be able to take out an impressive amount in dividends.
Drawbacks of dividends
For the most part, we’ve only discussed the advantages of dividends. But what are some of the drawbacks and disadvantages of taking dividends” Some drawbacks include:
- 1: When taking out dividends, you can only take them out of your profits
- 2: Dividends are not as reliable as an income, and you may find it difficult to make long-term financial plan
- 3: There are no benefits such as maternity leave, pensions etc. associated with taking dividends
- 4: Dividends are paid after tax deductions, unlike salaries (which are in fact tax-deductible)
- 5: If you mistakenly take out a dividend that cannot be covered by your business’s profits, you would have taken out a director’s loan. And this will need to be repaid; otherwise, you’ll encounter heavy tax penalties.
If you plan on relying solely on dividends for your income, you may want to invest in a reliable accountant and state-of-the-art accounting software so that you don’t make any mistakes. You’ll also need to rely on the fact that your business will profit. There are many business owners that rely solely on dividends as they don’t want to rack up their company expenses by taking out a salary. However, these types of people usually have a regular job on the side or access to a steady income, so they don’t need to worry about fluctuating profits and dividends.
Making use of a salary
As a company director, it is advisable that you take a monthly salary even if it’s a small one, as you may need a steady amount each month to cover your personal expenses and plan for long-term financial goals. Taking out a personal allowance of £12,500 is completely tax-free, so definitely advisable. When taking at least part of your income as a regular salary has many benefits, which include:
- 1: In the years that you take a salary, you’ll be building up to qualify for pension
- 2: As you’re technically an employee, you’ll get benefits such as maternity leave
- 3:You’ll be able to make higher personal contributions to your pension
- 4: You may find it easier to apply for things like rent contracts, mortgages etc if you can prove that you have a regular monthly salary.
- 5:By taking out a salary you are able to reduce the amount that your business has to pay in corporation tax as a salary is seen as an acceptable business expense
- 6: You’re able to take a salary even if your business doesn’t make a profit.
The above benefits are definitely substantial and should not be disregarded. Dividends get a good reputation for their tax efficiency, but there are definite advantages to having a regular monthly salary.
That being said, salaries also do come with their drawbacks and disadvantages, some of which include:
- If you take a salary, both you and your business will be subject to NICs (National Insurance Contributions)
- When taking a salary, you’ll be met with higher amounts of income tax.
But when the pros and cons are measured up against each other, taking a salary is definitely beneficial to most business owners. The question is just how much you should take.
The difference in tax structures
Like we have previously mentioned in this article, dividends attract lower tax penalties than salaries, and this is the main reason why business owners lean towards dividends over salaries. Dividend tax structures include:
- 1: The tax-free dividend allowance: £2,000
- 2: Standard rate: 8.75% on earnings up to £37,500
- 3: Higher tax level: 33.75% on earnings up to £150,000
- 4: Advanced rate: 39.35% on taxable income over £150,000
Salaries are taxed slightly differently. All salaries under the minimum threshold are completely tax-free, but as soon as you start going over that, you can expect to be faced with heavy taxes. The tax thresholds for salaries include:
- 1: Tax-free personal allowance: £12,570 pay
- 2: Basic rate: £12,571 to £50,270 you pay 20%.
- 3: Higher rate: £50,271 to £125,140 you pay 40%.
- 4: Advanced rate: over £125,140 you pay 45%.
So as you can see, the taxes on salaries are significantly higher than the taxes on dividends. What many company owners do is take out a tax-free personal allowance of £12,571 and take the rest through dividends. While many people opt to take a personal allowance of £12,571 to avoid tax, if you want to avoid National Insurance Contributions, you’ll need to take a personal allowance that is lower than £8,632, so you may want to consider NICs when deciding how much you should take in personal loans.
Whichever method you use, you will have to include your dividends and salary on your self-assessment when submitting your tax to the HMRC at the end of your financial year.
Keeping track of transactions
Whichever method you use, it is very important that you keep detailed records of all of your transactions. This way, when you do your self-assessment at the end of the business year, you’ll have everything you need, and you’re less likely to be questioned by the HMRC. It is advisable that you have a reliable accountant and make use of quality accounting software when keeping track of all of your business expenses.
Are there any other ways besides dividends and salaries to take income from your business?
While dividends and salaries are probably the most popular ways in which to receive an income from your business, there is a potential third way for your business to pay you out. And this solution comes in the form of taking employer pension contributions directly from your business. If you aren’t already doing this, you may want to look into this as an option, as some of the many advantages include:
- 1: These pension contributions won’t be seen as part of your income, and therefore won’t be taxed
- 2: They are seen as an allowable business expense, saving you from having to pay corporation tax
- 3: You don’t need to pay National Insurance Contributions on pension contributions
- 4: These contributions won’t be limited by the amount of your salary, and you can get as much as £40,000 per year into your pension even if you are on a small salary.
The only major drawback to this is that you are only able to access your pension when you turn 55. But it is a great way to start saving towards your retirement or simply have a large number of funds available to you when you have your 55th birthday.
Even if you are a young business owner, you won’t regret putting away money for retirement. In fact, the earlier you start, the better! You’ll definitely thank yourself in the long run, and this is a great way to invest in your future.
Other than taking a direct pension, there are no other sound or legal ways of extracting money from your company besides the traditional routes of a salary and dividends.
So, how should I take my income from my business?
There is no surefire answer that works for every business owner, but at the end of the day, all business owners need to walk away with at least some money in their pocket.
Whether you use a steady salary, dividends, or a mixture of both, and whether you choose to pay your pension contribution to yourself directly, will depend heavily on a variety of factors. These factors include:
- 1: Whether your business is brand new or already-established
- 2: How many directors/ shareholders are involved in your business
- 3: The amount that your business profits each year
- 4: Whether the profit can be relied upon or not
- 5: Your business expenses
- 6: How much income you need in order to cover your personal monthly expenses
- 7: If you’d rather have profits sitting in your pocket or have them re-invested into your business.