Tax efficient ways to pay yourself: salary or dividends?

Updated 10 May 2014: amended to include 2014/15 figures.

Updated 29 June 2013: amended to include 2013/14 figures.

A common and sensible question that small business owners trading through a limited company often ask is ‘how do I pay myself in the most tax efficient way’?

The answer to this question is refreshingly simple: use a mixture of salary and dividends.

Salary

Salary is the term used to describe money paid to you as an employee of the company. Money paid in this way must be taxed at source (i.e. by the company before it is passed to the employee). This scheme is called PAYE (Pay As You Earn) and ensures that companies deduct both income tax and national insurance from employees salaries and pay it directly to the tax man.

Pay £663 per month as salary

In most cases you should pay yourself a small salary that falls below the threshold for Income Tax and National Insurance. For the tax year 2013/14 this figure is £663 per month.

Dividends

Dividends are a distribution of profits by a company to its shareholders. As this definition suggests, dividends should only be paid if there is sufficient profit in the company to cover the payment.

Profits are taxed at 20%

The profits of a company are taxed through the Corporation Tax system. For small companies this is at a rate of 20%. So any money available for dividend payments will already be liable to tax at 20%, which must be paid by the company.

Individuals pay no additional tax on dividends received from the company

Until an individual’s income exceeds the higher rate tax threshold (a total salary of £41,865 for 2014/15) dividends are taxed at only 10%. However, the tax man has decided that it would be unfair to tax this money twice (once when it becomes profit and once when it is distributed to individual shareholders) so individuals can claim a ‘tax credit’.

Don’t worry about tax credits

Tax credits on dividends are difficult to understand. You don’t really need to worry too much about it, but it is helpful to understand that the cash paid out to you by the company technically only represents 90% of your ‘dividend income’. The other 10% is a notional tax credit that is never actually paid but is relevant for your tax return.

The important thing is that the tax has already been paid by the company so whatever cash you get from the company you can keep! The important caveat to note however is that once your taxable income exceeds the higher rate tax threshold (set out above), you will incur additional tax on your dividends at the rate of 22.5% (the notional rate is 32.5% but 10% is taken as paid within the tax credit).

Example of tax efficient payment

  • A total of £46,904 from the company is paid out as follows:
    • Salary of 12 x £663 = £7,956
    • Company profits of £38,948, subject to tax at 20%, leaves dividends to pay to you of £30,158
  • So total net income = £38,114 (total taxable income = £41,685, just below the higher rate threshold.

On this basis the effective tax rate is 19% which compares favourably to the 27% you would pay if you put all this cash through as salary (or 38% if you include the employer’s NI contributions). Note that the benefit deceases as your dividend payment exceeds the amounts above because you start to pay the additional 22.5% tax.

Additional considerations

If you use a good piece of accounting software (check out our ClearBooks review here) then this should create Dividend vouchers for you. Technically you should also approve the payment of dividends at a board meeting and create an official board minute recording this. The belt and braces approach would be to staple a set of management accounts showing sufficient profit to the voucher and board minute. As to how many companies actually do this, I couldn’t possibly speculate ;-)

If you want to find out more about day to day management accounting, check out my post on the basics of management accounting for small businesses.

Alternatively, why not read about how I save hours each day by checking my email only ONCE per day.

  • James Jordan

    Hi Andrew 

    Could you point in the direction where you got the figure for the 40% upper threshold limit of (42,475) please as I thought it was much lower thank this?
    Jim

    • http://www.business-beginnings.com/ Andy Pearson

       Hi James

      Thanks for your comment. It’s a good question. Technically the 2012/13 higher rate of tax applies from £34,371 to £150,000 (see the HMRC site: http://www.hmrc.gov.uk/rates/it.htm). However, this is on income over and above your personal allowance, which does not incur tax. Your personal allowance may vary (which is why HMRC splits this out) but the £42,475 threshold I mention in the post is based on adding in the standard personal allowance of £8,105.

      Hope that helps.

      Andy

  • Anthony Halliday

    Hey,

    Informative post. Only thing i’m curious about is employees NI of 13.8%. Doesn’t look like you’ve included this.

    Would be added to the salary reducing the company profits. Or have i missed something?

    Cheers

    • http://www.business-beginnings.com/ Andy P

      Thanks Anthony. You are right, the 29% figure I mention in the penultimate paragraph is from an employee perspective only. In the context of an owner paying him/herself through the business the saving on employers NI is just as valuable. Taking this into account the effective tax rate tops 40%.

  • Andrew

    If there are 2 directors does that make it 8.5% tax?

    • http://www.business-beginnings.com/ Andy P

      Hi Andrew. I’m afraid not. The calculations are the same for each director no matter how many there are.

  • JimKirk

    Hi Andy,

    Am I reading the figure for £34,687 wrongly?

    I mean, doesn’t 20% deducted from £43,743 leave you with: £34,987?

    Cheers for this write up!
    Jimmy.

    • http://www.business-beginnings.com/ Andy P

      Thanks Jim, good spot. The 6 should be a 9. I’ve corrected the post.

  • Matt

    Hi. I’m paid this way where I work but it is causing me problems as I’m trying to get a mortgage. Problem is I don’t show as having any gross income when I’m paid like this and brokers don’t seem to be able to compensate for this.
    I been offered a much lower amount than someone who earns much less than me! Is there anyway I could use the 20% tax the company pays as gross for my dividends or is there anything else you could recommend?

    • http://www.business-beginnings.com/ Andy P

      One of my co-directors managed to find a bank that would assess his income on the basis of the aggregate of salary and dividends. He had to prove this by producing his tax returns. The bank was Santander I believer. however, I’m afraid I have no first hand experience of this issue.

  • Aston

    How does the revenue tolerate this? It just seems too easy and with the Treasury cracking down on tax avoidance, surely it is only a matter of time before these schemes get caught and several years of back payments become due? Or am I being too cautious? IR35 for contractors was painful for many.

    • http://www.business-beginnings.com/ Andy P

      You are right to be cautious but I think the key issue here is that you are not trying to dupe the tax man. This structure only works if you can demonstrate that you are genuinely dividends out of the distributable profits of a legitimate company. So this is just sensibly structuring payments to make the most of the fact that companies are taxed slightly differently to individuals. The tax man has been well aware of this for years so if he thought it was a tax dodge I’m sure it would have been addressed. But, having said that, you need to consider all the information in front of you and make a decision that you feel comfortable with!

  • Aston

    Thank you Andy P. I think a mixture makes sense and easier to live with.

  • jon

    very interesting. what tax do you pay then if you get dividends of 140,000 sterling for example

    • http://www.business-beginnings.com/ Andy P

      First you ‘gross up’ your dividend (add 10%) to £155,555. Then you add the gross salary paid of £7,956, which takes you to a taxable income of £163,511. Because this figure significantly exceeds £100,000 you lose your personal allowance giving a revised higher tax rate threshold of £31,865. You then pay extra tax on everything over the £31,865 threshold. Your rate would be 21.6% (slightly higher because you edge over the £150K limit), so around £30,296 of tax. Of course you’ll have to check all of this with your accountant (I’m not one!).

  • sas

    Hi Andy – great article, really clear. Its the approach my business partner and I want to follow. What though if we pay ourselves at the end of the tax year in one lump sum. Does that trigger higher NI contributions? thanks

    • http://www.business-beginnings.com/ Andy P

      Thanks sas. As far as I know it shouldn’t affect your national insurance contributions if you pay the salary in a lump sum at the end of the year. I don’t have personal experience of this though and don’t know if there are any other issues that might arise (it does sound a bit unusual). However, HMRC publish thresholds on a weekly, monthly and annual basis which I assume is to address this situation. Here are the 2013/14 thresholds: http://www.hmrc.gov.uk/payerti/forms-updates/rates-thresholds.htm

  • vickie

    Thank you that was really helpful

    • http://www.business-beginnings.com/ Andy P

      Cheers Vicki. Glad you found it useful.

  • Paul

    If you pay yourself a salary below the NI threshold, does that have an impact on your entitlement to the state pension as you will have fewer qualifying years?

    • http://www.business-beginnings.com/ Andy P

      Good Question Paul. The threshold at which you are deemed to be working and thereby qualify for state pension etc. is the ‘lower earnings limit’. This is £111 per week, or £481 per month for 2014/15. The rate at which NI starts to be charged is higher – currently £663. So if you follow the approach described above you should not run into this entitlement problem.