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What’s the best way for a director to pay themself?

Assuming you run a business (regardless of whether it’s a solo lifestyle business or multi-employee firm) here are three distinct ways that you can pay yourself: dividends, pension contributions and salary. Specifically, let’s consider the benefits of dividends and pensions, alongside the limitations of these types of income.

How can I receive an income from my business?

Most business owners pay themselves in a mixture of salary and dividends, complimented by pension contributions. Finding the right blend for you will rely upon several variables, for example:

  • The availability of profits
  • The amount you want to reduce your own personal tax
  • The amount you need to reduce corporation tax
  • Whether you want to keep maternity or state benefits

Taking a salary from your company

As a company director, it’s wise to pay yourself a small salary. This means putting yourself on the payroll. There are a few advantages of taking part of your income as salary.

The advantages of taking a salary

  • You develop contributions towards your pension
  • You can make higher individual pension contributions
  • You can maintain maternity benefits
  • It’s easier to apply for a mortgage and insurances
  • You pay less corporation tax
  • Even if the business makes no profit, you can still take a salary

That said, there a few disadvantages to taking a salary.

The downsides of taking a salary

  • Both you and the business will need to pay National Insurance
  • A salary will attract higher income tax than dividends

Choosing how much salary to take

You don’t pay tax on any earnings until you pass your allowance threshold (currently £12,570 in 2022/23).

Receiving dividends as income

Some business owners decide to take most of their income as dividends, as this is typically more tax efficient.

So, what are dividends?

A dividend is just a portion of company profits. Profit is what is left over after the business has settled every one of its liabilities, including taxes. If the business doesn’t make any profit, then no dividends can be paid.

They can be paid to shareholders and directors of the business, according to the proportion of shares they hold. There is no requirement to pay all profits as dividends. A business could retain them and distribute as it chooses.

The advantages of taking dividends

  • It will attract lower rates of income tax than salary
  • National Insurance contributions are not payable on dividends

By having most of your income as dividends, you can essentially lower your income tax bill.

Dividend allowance

In addition to your personal allowance, you have a tax-exempt, dividend allowance. In the 2022/23 financial year, this is £2,000. This therefore means that you can earn up to £14,500 before paying any income tax whatsoever.

Income tax rates for dividends

Sarah takes a salary of £8,600 (keeping below the threshold for paying NICs or income tax on it) and takes a further £30,000 in the form of a dividend. Her total income is now £38,600. She has a tax-free personal allowance of £12,570, leaving £26,030. Her dividend allowance means the first £2,000 of dividends are tax-free, leaving £24,030 that is taxable.

This £24,030 is taxed at the dividend basic rate of income tax, which is just 7.5 per cent. So, Sarah’s income tax bill for the year will be £1,802.

If Sarah had taken the whole £38,600 as salary, then her income tax bill would have been 20 per cent of £26,030 – which is £5,206. She would also have to pay £3,596 in NICs.

By taking her income in a combination of a low salary plus dividends, Jane has saved over £7,000 in that year.

Also note that the company would have to pay employer NICs on her salary, coming in at £4,135.

However, this will be offset to some extent by lower corporation tax.

The disadvantages of taking dividends

Although having income as dividends might appear like an easy decision, there are sure things to look out for.

  • Dividends can only be paid out of profits
  • Depending too much on dividend income can make income unpredictable
  • They are paid after corporation tax has been deducted (the opposite to salary, which is a tax -deductible expense)
  • If you take a dividend that isn’t covered by profit, you will have taken out a director’s loan which needs to be reimbursed.

If you intend to rely on dividends for some or the greater part of your income, then you’ll need to ensure you have a thorough bookkeeping and accounting partner. They can assist you with working out which strategy is most cost effective for both yourself and your business, as this can be quite tricky.

Getting pension contributions from your business

A third way for receiving tax-efficient income is pension contributions from the business.

The benefits include:

  • They don’t add to your income, so they won’t increase your tax bill
  • They are an admissible operational expense, saving you up to 19% in corporation tax
  • There are no employer NI contributions to pay, saving another 13.8%
  • Pension contributions are not restricted by the size of your salary

The last point above is a significant one. As an individual, you are not allowed to pay more into your pension pot in a year than your salary for that year. Consequently, if you take a little salary in addition to dividends (as examined above) you can’t pay that much into your pension.

However, employer contributions are not limited like this. They are limited only by the yearly allowance of £40,000. So, your organization can contribute up to this amount into your pension, regardless of whether you are on a small salary.