If you run your own limited company, one of the first questions that comes up is how to pay yourself. Unlike being employed, where a salary is the only option, company directors usually have a choice between salary, dividends or a mix of both. Getting this right matters. It affects how much tax you pay personally, how much National Insurance the company pays and how efficiently profits move from the business into your pocket. There is no single answer that works for everyone but understanding how each option works makes it far easier to have an informed conversation with your accountant.
Here is a guide to how director pay works, the pros and cons of each approach and what to think about when deciding what suits you.
How director pay works
As a director and shareholder of your own limited company, you are in a slightly unusual position. You can be paid a salary through payroll like any other employee and you can also receive dividends as a shareholder when the company has made a profit.
The two are treated very differently:
- Salary is a company expense. It reduces the company’s profit before corporation tax, but it is subject to Income Tax and National Insurance, both for you personally and for the company.
- Dividends are paid out of profit after corporation tax has already been deducted. They are not subject to National Insurance, but they are taxed at dividend tax rates once they exceed your tax-free dividend allowance.
Most director-shareholders end up taking a combination of the two, structured to make use of tax-free allowances and lower rate bands as efficiently as possible. The right balance depends on your personal circumstances, how much profit the company is making and what else is going on in your tax affairs that year.
Benefits of taking a salary
Taking at least a small salary has some clear advantages, even though salary is taxed less favourably than dividends once you go beyond a certain point.
- It counts towards your State Pension. A salary above the Lower Earnings Limit builds up qualifying years for the State Pension, even if no National Insurance is actually payable at that level.
- It is a deductible business expense. Salary reduces the company’s profit before corporation tax is calculated, which can lower the company’s tax bill.
- It supports mortgage and lending applications. Some lenders and other financial institutions look more favourably on a documented salary than on dividend income alone.
- It can be paid even when the company has not made a profit. Salary is not dependent on distributable profits in the way dividends are.
For many directors, a modest salary set at or around the National Insurance threshold is the starting point, with dividends used to top up income beyond that.
Benefits of taking dividends
Dividends tend to become more attractive once income moves beyond the level a salary alone would efficiently cover.
- No National Insurance is payable on dividends. This can make them considerably more tax-efficient than salary once basic thresholds have been used.
- Dividend tax rates are lower than equivalent Income Tax rates. At each band, dividend tax rates are lower than the corresponding rate that would apply to salary.
- Dividends can be timed with more flexibility. Because they depend on when the company declares them, dividends can sometimes be planned around your personal tax position, for example spreading income across tax years.
- They are simple to administer. Dividends do not need to run through payroll and do not create the same ongoing reporting obligations as an employee salary.
The key condition is that dividends can only be paid out of retained, distributable profits after corporation tax. Paying dividends when the company has not made sufficient profit can create real problems, so this always needs to be checked before a payment is made.
Tax efficiency considerations
There is no single salary and dividend split that works for every director and the right structure can change from year to year. Some of the main factors that affect this include:
- Personal allowance – salary is usually set to make use of your tax-free personal allowance, since this is available before any tax is due at all.
- Dividend allowance – a small amount of dividend income is tax-free each year and it makes sense to use this fully before considering other income.
- National Insurance thresholds – salary levels are often set carefully around thresholds so National Insurance is minimised while pension qualifying years are still protected.
- Corporation tax – because dividends come from profit after corporation tax, the overall tax paid across the company and the individual needs to be looked at together, not in isolation.
- Other income you receive – if you have income from other sources, this can push you into a higher tax band and change what the most efficient structure looks like.
- Changes each tax year – allowances, thresholds and rates are reviewed and often changed at each Budget, so a structure that worked well last year may not be the best approach this year.
This is exactly why salary and dividend planning should be reviewed annually rather than set once and left alone. What was efficient a couple of years ago may no longer be the case.
Example pay structure
To bring this to life, a common approach for a single director of a small limited company might look something like this:
- A salary set at a level that uses the personal allowance and protects State Pension qualifying years, without triggering unnecessary National Insurance.
- Dividends paid on top of this, using the tax-free dividend allowance first, with any further dividends taken up to the point that suits the director’s overall tax position.
- The balance reviewed each year in light of profits, personal circumstances and any changes to tax rates or thresholds.
This is a simplified illustration rather than a recommendation. Every business and every director’s circumstances are different and the right structure depends on company profits, other personal income, future plans for the business and a number of other factors that are worth talking through properly.
Getting your salary and dividend structure right can make a genuine difference to how much of your company’s profit you keep. If you would like to talk through what would work best for you and your business, we would love to help. Call us on 01173 700 079 or drop us an email at hello@steppingstonesaccountancy.co.uk and we can have a straightforward conversation about your options.
