Should I take a salary or dividends as a business owner?

salary or dividends

Should I take a salary or dividends as a business owner?

If you own a small business and are also a shareholder director, you may wonder whether to take a salary or dividends.

When it comes to paying yourself, there are both advantages and disadvantages to each option, including potential tax savings.

We’ll explore how taking salaries versus dividends for shareholder directors of small businesses in the UK may affect the money you take home.

How can you remunerate directors? 

The UK tax system allows company shareholders to draw money from their companies in two ways.

You can take a PAYE salary, which is subject to Income Tax and National Insurance Contributions (NICs), or by taking dividends, which are instead subject to dividend tax rates and free of NICs.

Why consider taking a salary?

There are two primary reasons, beyond the earnings, for drawing at least part of your remuneration as salary from your business.

First and foremost, you will likely want to continue to accrue qualifying years towards your state pension. To obtain the National Insurance credits to receive this benefit, the salary will need to be over the current Lower Earnings Limit (£6,396 in the 2022/23 tax year).

When setting your salary, many directors choose a level between the Lower Earnings Limit and the Primary Threshold (£11,908 per annum for directors), as this will ensure you receive National Insurance credits but will avoid having to make regular National Insurance Contributions.

Secondly, taking a salary counts as an allowable business expense, which you can offset against your profits to reduce the amount of Corporation Tax your company is liable for.

How should you set a salary?

If you intend on drawing money from your business but want to maintain contributions towards state pensions and other benefits, then taking salary instead of dividends might be right for you. 

Your salary may affect your income tax position. Every UK taxpayer enjoys a personal tax allowance of £12,570 per annum (frozen until 2028).

Any earnings above this amount, including income from a salary, will be taxed at your marginal rate (basic, higher and additional).

If your salary exceeds these tax bands thresholds, you will pay a higher tax rate alongside other earnings outside your salary could carry you over into higher tax rates.

Be wary that this is particularly precarious from April 2023, when the additional income tax rate threshold (45%) falls from £150,000 to £125,140.

Why take dividends instead of a salary? 

Dividends, unlike salary payments, do not attract NICs, and the tax rates on dividends are lower than on salaries.

However, you must ensure shareholders vote correctly for dividends and that the company has sufficient distributable reserves.

However, if your annual dividend payments exceed £2,000 per year (based on the current dividend allowance), you will need to pay some tax.

This dividend tax allowance will be reduced from April 2023 to £1,000 and halved again to just £500 in the following tax year. Dividend tax rates remain lower than income tax rates and may offer a tax advantage to some directors.

For 2022/23 and into the new tax year, the dividend tax rates are:

  • Basic rate: 8.75%
  • Higher rate: 33.75%
  • Additional rate: 39.35%

How to balance dividends and salary 

You must consider both options carefully before deciding which works best for you based on your current financial situation and plans.

Usually, directors will choose a combination of both dividends and salary to manage their tax position and that of their company without reducing their access to benefits, such as a state pension. With tax rates and allowances changing yearly, you must review your position regularly.

It is essential to weigh all these factors carefully before deciding on a remuneration approach for you and any other directors of the business. Seeking regular professional advice can be particularly beneficial as your circumstances may change from one year to the next. Our tax team can help, arrange a free consultation.