Dividend vs Salary: What Is More Tax-Efficient for Company Directors?

One of the most common tax questions for limited company directors is how to structure their income. Should you pay yourself a salary, take dividends or use a combination of both?

The answer matters because salary and dividends are taxed differently, and the right combination can significantly reduce the amount of tax you pay without doing anything complicated or aggressive.

This article explains how salary and dividends are taxed, how most directors structure their income and what factors you need to consider.

How Salary Is Taxed

When you pay yourself a salary from your limited company, two things happen.

First, the salary is a deductible expense for the company, which reduces the company's taxable profit and therefore its corporation tax liability.

Second, you pay Income Tax and National Insurance contributions on the salary as an employee, and the company pays employer National Insurance contributions on top.

Income Tax is charged at the basic rate, higher rate or additional rate depending on your total income. National Insurance contributions are charged at employee rates on earnings above the primary threshold and at employer rates on earnings above the secondary threshold.

National Insurance is a significant cost. Employee National Insurance contributions and employer National Insurance contributions together represent a meaningful additional tax burden on salary income that does not apply to dividend income in the same way.

How Dividends Are Taxed

Dividends are paid from a company's after-tax profits. This means the company has already paid corporation tax on the profits before distributing them as dividends.

You do not pay National Insurance contributions on dividend income. This is the key tax advantage of dividends over salary for most directors.

You do pay Income Tax on dividends above your annual dividend allowance, but at rates that are lower than the equivalent Income Tax rates on salary. Dividend tax rates apply separately from your standard Income Tax bands.

Because dividends are paid from after-tax profits, there is an element of double taxation involved. The company pays corporation tax on the profit, and you then pay dividend tax on what you receive. However, the combined tax burden is typically lower than the combined Income Tax and National Insurance burden on the equivalent amount taken as salary.

The Most Common Director Income Structure

Most tax advisers recommend that company directors take a small salary combined with dividends. The logic works as follows.

The Salary Element

The salary is typically set at a level that is high enough to count as a qualifying year for State Pension purposes but low enough to avoid triggering significant National Insurance contributions.

There are two common approaches. Some directors set the salary at the National Insurance lower earnings limit, which preserves the State Pension qualifying year without triggering any National Insurance liability for the employee or employer. Others set the salary at the primary threshold, which is the point at which employee National Insurance contributions start, to maximise the corporation tax deduction while keeping National Insurance costs to zero or minimal.

The employment allowance, which reduces an employer's National Insurance bill by a set amount each year, may affect this calculation for some companies. Sole director companies are not eligible for the employment allowance.

The Dividend Element

Additional income is taken as dividends from the company's after-tax profits. Dividends are paid up to whatever level is needed to meet personal income requirements, up to the point where higher rate dividend tax starts to apply.

Once dividends would push total income into the higher rate band, the tax saving compared to salary narrows, though dividends can still be more efficient than salary at higher income levels because of the absence of National Insurance.

Working Through a Simple Example

Consider a director whose company makes a profit of £60,000 before any salary or dividends.

If the director takes a salary at the primary threshold and takes the remainder as dividends, the total tax paid by the company and the director combined is typically lower than it would be if the director took the full amount as salary.

This is because the dividend income is not subject to National Insurance, and the combined rate of corporation tax plus dividend tax is lower than the combined rate of Income Tax plus National Insurance on salary income at most income levels.

The exact saving depends on the current tax rates, thresholds and allowances, which change each tax year. An accountant can model the numbers for your specific situation.

Factors That Affect the Calculation

The optimal salary and dividend split is not the same for every director. Several factors affect the calculation.

Your Other Income

If you have other income sources, such as rental income, employment income or savings interest, your personal allowance and tax bands may already be partly or fully used. This affects how much you can take as salary or dividends before higher tax rates apply.

The Dividend Allowance

There is an annual dividend allowance above which dividend income is taxable. This allowance has reduced significantly in recent years. Once your dividends exceed the allowance, dividend tax applies at rates that depend on which Income Tax band your total income falls into.

Corporation Tax Rate

The rate of corporation tax your company pays affects the overall calculation. A higher corporation tax rate means the company retains less profit to distribute as dividends, which changes the relative efficiency of salary versus dividends.

Employment Allowance Eligibility

The employment allowance reduces an employer's National Insurance liability by a set amount each year. However, companies where the sole employee is also a director are not eligible. This affects the cost of salary for single-director companies.

State Pension Qualifying Years

To qualify for the full new State Pension, you need a minimum number of qualifying years of National Insurance contributions. If you set your salary below the lower earnings limit, the year may not count as a qualifying year. Most directors set their salary at least at the lower earnings limit to protect their State Pension entitlement.

IR35 and Off-Payroll Working Rules

If your company is caught by IR35 or the off-payroll working rules, the tax advantages of operating through a limited company are significantly reduced. Under these rules, income from the relevant contract is treated as employment income for tax purposes, meaning you pay Income Tax and National Insurance as if you were an employee.

If IR35 applies to your work, the salary and dividend structure that works for other directors may not be available to you in the same way.

What About Retained Profits?

One advantage of a limited company structure is that you do not have to extract all the company's profit each year. You can choose to leave profits in the company, pay corporation tax on them and extract them in a later tax year when it is more efficient to do so.

This is useful if you are planning to reduce your working hours, take a career break or are approaching a period where your personal income will be lower. By deferring dividend extraction to a lower income year, you can reduce the rate of dividend tax you pay.

Retained profits in a company can also be used to fund business investment or to build a reserve for future expenses, rather than extracting them all as personal income.

Common Mistakes Directors Make

Taking Too Much Salary

Taking a salary significantly above the National Insurance threshold generates a large National Insurance bill for both the director as employee and the company as employer. Unless there is a specific reason to take a higher salary, this is generally inefficient.

Not Checking Whether Sufficient Profit Exists

Dividends can only be paid from distributable profits. If a company pays dividends when it does not have sufficient retained profits to support them, those dividends are unlawful. Make sure your company's accounts are up to date before declaring a dividend.

Not Documenting Dividends Correctly

A dividend payment must be formally declared by the directors and documented with a board minute and a dividend voucher. Treating informal withdrawals from the company account as dividends without the correct documentation creates tax and legal problems.

Ignoring the Impact of Other Income

Directors with other significant income sources sometimes optimise their salary and dividend structure without accounting for the income they already have. The result can be a higher tax bill than expected because personal allowances and basic rate bands are already used.

Not Reviewing the Structure Each Year

Tax rates, thresholds and allowances change each year. The optimal salary and dividend split in one tax year may not be optimal the following year. The structure should be reviewed annually.

Getting the Numbers Right

The salary versus dividend decision is one of the most straightforward ways for a company director to manage their tax bill efficiently. It does not involve any aggressive tax planning, it is widely used and it is supported by the way the UK tax system treats company income.

However, getting the numbers right requires an up-to-date understanding of current tax rates, thresholds and allowances, and it needs to account for your personal circumstances rather than using a generic figure.

Qestor Chartered Accountants helps limited company directors structure their income efficiently, review the right salary and dividend split each year and make sure dividends are documented correctly. If you are a director and you are not sure whether your current income structure is as efficient as it could be, a conversation with an accountant is the best starting point.

Frequently Asked Questions

Is it legal to pay yourself mostly in dividends as a director?

Yes. Taking a low salary combined with dividends is a legitimate and widely used approach for company directors. It is not a tax avoidance scheme. It simply uses the tax system as it is designed to work for company income.

Can I pay myself dividends whenever I want?

Dividends must be paid from distributable profits. Before declaring a dividend, make sure your company has sufficient retained profits to support it. Each dividend payment should be documented with a board minute and a dividend voucher.

What happens if I pay myself too much in dividends and the company does not have the profits?

If a company pays dividends without sufficient distributable profits, those dividends are unlawful. They may need to be repaid to the company and could create personal tax problems if they have been treated as dividends rather than as a loan.

Does the salary and dividend approach work if I am caught by IR35?

No. If IR35 applies to your contract, the tax advantages of the salary and dividend structure are significantly reduced. Income from the relevant contract is treated as employment income regardless of how it is extracted from the company.

How often should I review my salary and dividend structure?

Annually. Tax rates, thresholds and allowances change each year, and your personal income situation may change too. Review the structure at the start of each tax year with your accountant.