Optimising the Salary vs Dividend trade-off
This blog expands on a point we made in our earlier general tax saving guide and looks in more detail at how best to take regular money out of an owner managed limited company in terms of dividends and or salary.
In all instances we need to examine the tax implications both for the company and the owner as a tax paying individual and assume that the lowest overall tax burden when combining both such liabilities will be preferred. For this we need to consider four different taxes – Income tax and National Insurance (NI) for employees plus Corporation Tax and NI for employers.
All calculations are based on the tax rates applying to the year ending 5/4/2020.
The basic trade-off
Dividends are not a deductible expense. They can only be paid out of after tax profits which means that the company will incur a tax rate of 19% in order to pay them. In the hands of the owner, the personal tax rate is 0% for the first £2,000 of dividends and any unused portion of the £12.5k personal allowance limit. Thereafter, the rate rises to 7.5% for total income upto the basic rate limit (£50k), 32.5% for income upto the higher rate limit (£150k) and then 38.5% for any income beyond that (the additional rate).
In contrast, salaries are a fully deductible expense and the company will incur no corporation tax to pay them. However, beyond an annual limit of £8.6k (the Secondary Threshold – ST), employers must pay Employers’ National Insurance contributions of 13.8%. For small companies, the first £3k of National Insurance is not payable. In the hands of the owner, the personal tax is 0% upto the £12.5k personal allowance followed by 20% upto the basic rate limit (£50k), 40% for income upto the higher rate limit (£150k) and then 45% for any income beyond that (the additional rate). Additional employees must pay National Insurance contributions of 12% on any pay beyond £8.6k (the Primary Threshold – PT) although this drops to 2% after a salary of £50k (the Upper Earnings Limit – UEL).
The resulting aggregate tax burdens are as follows:
Particular points to note
Where the business has other employees which fully utilise the employer’s NI, the owner’s salary should be capped at the £8.6k ST limit
Where owners make use of Salary Sacrifice, then salaries will require inflating upto at least the minimum wage (£8.21/hr if 25 years old or more) otherwise such schemes won’t work.
The company can only pay dividends out of cumulative and positive retained earnings ie where the company has made overall losses (over all years), owners can only draw a salary.
Finally, a peculiarity of the state pension scheme is that paying a salary above the £6.1k LEL but below the £8.6k PT will provide a qualifying year for NI without having made any NI payments! You need a minimum of 10 years and a maximum of 35 years to qualify for the current £164/week state pension.
To minimise the overall tax burden, owners of limited companies should pay themselves a small salary upto the point at which Employer’s NI is due £8.6k (£11.6k where they have no other employees and can claim the NI rebate). Everything else should be paid as a dividend where the company is profitable.
If you haven’t already, make sure to download our tax saving tips, which is a free, in-depth guide that can ensure you save valuable funds wherever possible.