Salary vs dividends – What’s the best way to pay yourself?
Personal Tax Planning,
Wealth planning & Private client,
Corporate Tax Planning
One of the key decisions for owner-managers of businesses is how to pay themselves. The two main options available for those who have moved to a limited company structure are salaries and dividends. While both methods have their own advantages and disadvantages, choosing the right one can make a big difference to the financial health of the company and its owners. With changes to both the dividend allowance and corporation tax thresholds on horizon, it also pays to regularly review your income strategy to ensure you’re making the most of the reliefs available.
We explores the impact of changes in tax legislation, crunches the numbers on how to balance salaries and dividends as well as explaining how to consider your income holistically from a business point of view.
Understanding Salary and Dividends
Salaries are the fixed amounts paid to employees on a regular basis, which are subject to income tax and national insurance contributions (NICs). Dividends, on the other hand, are payments made to shareholders out of the company's profits after tax. Dividends are subject to income tax, but not NICs.
The right mix of the two will depend on your target income, the amount of cash and distributable reserves generated in your business and the tax planning strategy. This is why it's essential to review your income in line with the latest changes in legislation, including:
- Corporation Tax is increasing from 19% to 25% from 1 April 2023. The 19% rate will still apply if the company's profits are £50,000 or less, but more tax will be paid on profits above this level. Companies with annual profits of £250,000 or more will pay the full 25% rate, while between the two rates, a system of marginal relief will apply.
- Dividend Allowance will drop from £2,000 to £1,000 from 6 April 2023.
- The threshold for the highest rate of income tax (45%) is reduced from £150,000 to £125,140 per annum from 6 April 2023.
To understand the detail on these changes, we ran some sample figures to help guide planning for business owners.
How to balance salary and dividends
The short answer for business owners is that for basic rate taxpayers, paying dividends is nearly always the better option, regardless of changes in the Corporation Tax (CT) rate the company pays. This is because dividends do not attract NICs and offer tax advantages for lower rate taxpayers.
However, for higher rate and additional rate taxpayers, paying bonuses rather than dividends could be more beneficial, where the company will pay higher rates of CT from April 2023. The company can obtain a full deduction for the bonus, along with the employers NIC. This may provide additional tax relief and cash flow advantages.
Additionally, companies that fall into the marginal rates of CT may benefit from replacing dividends with bonuses. Although the differential between bonus and dividend is small (between 1-2%), the effective rate of tax on profits extracted for these companies is 26.5%.
- Profits of £50,000 – taxed at 19% = £9,500
- Profits of £60,000 – taxed at marginal rates = £12,150
The difference in this case is £2,650, meaning the effective rate on an additional £10,000 is 26.5%.
It should not be overlooked that many companies may have relatively modest profits but still fall within marginal rates simply because they are associated with other companies under common control.
It’s important to note that these are illustrative figures, and they may vary slightly by case and depending on NIC relief. However, the clear picture is that with new rates, dividends are now not always the strongest tool for profit extraction.
How to approach bonuses
While dividends will be the most advantageous course of action for most business owners, the use of bonuses should not be discounted for those individuals and companies paying higher rates of tax. On a broader aspect, the payment of bonuses instead of dividends could also provide other benefits.
- Paying bonuses could enable companies that are eligible for research and development credits to receive a higher refund of CT. This is because the bonus is considered pre-tax expenditure, as opposed to post-tax dividends.
- Replacing dividends with bonuses may provide cash flow advantages in reducing payments on account via self-assessment. However, this assumes that tax codes and applied rates under PAYE to bonuses are correct.
- Bonuses increase the capacity to contribute to pensions as these would be treated as net relevant earnings, unlike dividends. This means that paying a bonus may increase the amount that can be contributed to a pension scheme and may provide additional tax relief, especially given the increase in annual allowance levels recently announced.
- Paying NIC on bonuses may increase entitlements to benefits, such as jobseeker's allowance and statutory sick pay
While bonuses shouldn’t be considered a replacement for dividends, a managed strategy can include both to maximise personal and business benefit.
How we can help you extract more value
There is no one-size-fits-all approach when it comes to paying yourself as an owner-manager of a business. Deciding whether to pay yourself a salary or dividends depends on a range of factors, such as the CT rate, the profile of the company and its shareholders.
While dividends will often be the best option, paying bonuses could offer tax relief and cash flow advantages for some companies. It is important to consider all the factors – that’s why we work closely with our clients to understand their needs and those of their business to ensure that our strategies are tailored, up to date and effective for their goals.
To find out more about how to get paid in the best way for you and your business, get in touch with one of our experts.