Paying yourself from your limited company? The salary vs. dividends decision could save you thousands in tax. Discover how a strategic split can legally minimise National Insurance and optimise your take-home pay.
When it comes to paying yourself, whether you are a business owner, a freelancer, or even an entrepreneur running your own startup, one of the key decisions you’ll need to make is whether to pay yourself through a salary or dividends.
Both options come with their own set of advantages and drawbacks, and the right choice depends on factors like your business structure, personal goals, and tax considerations.
But what exactly is the difference between a salary and dividends? And how do they stack up in terms of tax implications, income flexibility, and overall financial strategy?
What is a salary?
A salary is a fixed, regular payment typically paid monthly or bi-weekly, based on an agreed-upon amount. As an employee, your salary is set at a certain amount and is not affected by the company’s performance.
For instance, if you are the business owner of a limited company, paying yourself a salary means you’re treating yourself like an employee, subject to income tax, National Insurance (NI) contributions, and potentially pension contributions.
In a more traditional employment sense, a salary is stable and predictable, which makes it easier to plan and budget. It also entitles you to various employment benefits, such as sick pay, holiday pay, and other employee protections (depending on your country’s laws).
If you own a business and pay yourself a salary, you’re essentially doing so under the same conditions as other employees, making it a straightforward option in many cases.
What are dividends?
On the other hand, dividends are payments made to shareholders from a company’s profits. Dividends are typically paid on a per-share basis and can be issued quarterly, semi-annually, or annually, depending on the company’s structure and its policy on profits.
In the context of a limited company, dividends can be a powerful tool for business owners. When you make a profit, you can choose to pay yourself a dividend rather than a salary. Dividends come from the company’s after-tax profits, which means they’re paid after the company has already paid corporation tax.
Dividends have the added advantage that they are often taxed at a lower rate compared to salaries, which makes them an attractive option for business owners looking to minimise their personal tax liability.
However, to pay yourself dividends, you must first ensure that your company is in profit and has retained earnings (money left after expenses, taxes, and salary payments).
Salary vs. dividends: The key differences
Now that we know what a salary and dividends are, let’s break down the key differences between the two:
1. Taxation:
Salary: When you pay yourself a salary, it’s subject to income tax, as well as National Insurance contributions (in the UK) or Social Security taxes (in other countries). These taxes are automatically deducted by your employer (which in this case, is your company). Depending on your income level, your salary could fall into a higher tax bracket, which could increase the amount of tax you pay.
Dividends: Dividends, however, are usually taxed at a lower rate compared to salaries. In the UK, for example, the dividend tax rates are lower than the income tax rates for salaried income. For the 2023-2024 tax year, the basic dividend tax rate is 8.75%, the higher rate is 33.75%, and the additional rate is 39.35%. Meanwhile, salaries are taxed at rates that can range from 20% to 45%, depending on your income bracket.
Another benefit of dividends is that you don’t have to pay National Insurance on dividend income (unless you’re self-employed in certain countries, in which case it may be different). This can lead to significant tax savings, especially for business owners who are not drawing a large salary.
2. Stability vs. flexibility
Salary: A salary provides a stable, predictable income. This is especially important if you rely on consistent cash flow for your personal finances or have regular financial commitments (like a mortgage, rent, or family expenses). A salary can make it easier to secure loans or mortgages, as lenders typically like the security of a steady income.
Dividends: Dividends, on the other hand, offer more flexibility. Since they’re paid out of profit, the amount you can pay yourself depends on how well your business is doing. During lean times, you might not be able to afford paying dividends, while during good times, you could take a larger amount. This flexibility is great for those who don’t need a fixed income and are comfortable with varying cash flow.
3. Retirement contributions and benefits
Salary: Salaries often come with the opportunity to contribute to retirement plans or pensions. If you’re drawing a salary, your employer (your company in this case) may offer pension contributions, which can help you save for retirement in a tax-efficient way. In some countries, there are also additional benefits like health insurance, paid leave, or sick days that you wouldn’t get if you were just taking dividends.
Dividends: Dividends do not typically come with pension or benefit contributions. This means that if you choose to pay yourself with dividends, you’ll need to make your own arrangements for retirement savings. In the UK, for example, you could set up your own personal pension scheme to make contributions. However, this can be less tax-efficient than salary-based pension contributions.
4. Cash flow impact
Salary: A salary, while predictable, takes a fixed amount of cash out of your business every month, regardless of whether the business is making a profit or not. This could be a burden on your business if cash flow is tight, as the business has to find the funds to pay you your set salary.
Dividends: Paying dividends can have a lesser impact on cash flow, as dividends are only paid out when the company has retained earnings. This gives your business more flexibility when cash flow is inconsistent.
5. Compliance and reporting
Salary: When you pay yourself a salary, it’s relatively simple from a compliance perspective. The salary is processed through the company’s payroll system, and taxes and National Insurance contributions are automatically deducted and reported to the relevant authorities.
Dividends: Paying dividends can be slightly more complex. Dividends require the company to declare and distribute profits, and you must ensure that the company has sufficient retained earnings to cover the dividend. Additionally, you’ll need to file the dividend payment in the company’s accounts, which may require more paperwork and attention to detail.
Which option is right for you?
The decision between salary and dividends depends largely on your personal and business goals. Here are some factors to consider:
- Stable income needs: If you need a stable, predictable income for personal expenses, a salary might be the better option.
- Tax efficiency: If you’re looking to minimise tax liabilities and have the flexibility to manage fluctuating income, dividends could be more tax-efficient.
- Pension contributions and benefits: If pension contributions or other employee benefits are important to you, a salary might be the way to go.
- Business health and cash flow: If your business has inconsistent profits, taking dividends might offer more flexibility, while a salary could strain the business’s cash flow.
Final thoughts
Ultimately, the decision between salary and dividends isn’t one-size-fits-all, it depends on your unique situation, your company’s performance, and your financial goals. There are benefits and drawbacks to both, and the ideal approach might involve a bit of a mix.
Always consult with a tax professional or accountant who can help you navigate the intricacies of both salary and dividends to make the best decision for your financial future.
Remember, what works best for you today might change as your business grows or as your personal circumstances evolve, so keep re-evaluating your strategy to ensure it continues to meet your needs.
