Earning an income from your business is not as straightforward as it sounds, as there are a variety of options available, including salaries and dividends.
Both options have advantages and disadvantages, and any decision on which system to use will depend on your business and your individual circumstances. Salaries and dividends are both income streams, one rewards you for services to your company while the other you buy as an investment.
By getting the right advice at the start of their business journey, owners can set up their company in such a way to extract the benefits and income they require, while reducing their tax burden. How you earn money needs to be part of your financial strategy.
So what are the differences between a salary and a dividend?
Earning a salary
Business owners can treat themselves like an employee and pay themselves a regular salary each month. This sounds simple enough, but there are a few points to consider:
- If you have an employment contract, you must comply with the National Minimum Wage. Many directors or shareholders choose not to do this as it has other consequences.
- If you earn £8,788* per annum a director pays no national insurance, but can still qualify for a company pension, sick pay and other benefits.
- When a business has unused Employers Allowance, it is common to pay the director a salary up to the annual personal allowance of £12,500* per annum.
The pros and cons
Company directors are usually advised to earn a small salary to show that they are on the payroll. Other benefits of taking your income in the form of a salary include:
- Having a salary contributes to your state pension and you can make higher personal pension contributions
- You maintain maternity benefits
- It can help your credit score, making it easier to apply for finance and life insurance or critical illness cover
- Salaries are an allowable business expense, so you lower the corporation tax burden
- Your salary does not depend on your business making a profit.
The cons of taking a salary:
- You and your business will need to make National Insurance contributions (NICs)
- Salaries attract a higher rate of income tax than dividends.
Taking a dividend
Earning a dividend means you enjoy a share of your company’s profits (after tax). The main downside is that if your business does not return a profit, you cannot earn a dividend.
Dividends are paid to all shareholders, based on the amount of shares they own. Businesses are not required to distribute profits every year as dividends, and can keep the cash on the books to distribute at a later date.
Investment income does not fall under the National Insurance umbrella, so dividends are regarded as a tax-efficient method to earn money from a business.
Dividends are tax free for the first £2,000 per annum, and then the tax rate will be either 7.5% or 32.5%* depending on your other personal income.
The pros and cons
As we have seen, there are tax benefits for choosing dividends, here is a summary:
- Dividends attract lower income tax rates than salaries
- No National Insurance contributions
- Dividends are passive income
- By investing in company shares, your investment can be repaid in many ways.
The cons of taking a dividend:.
- Dividends are reliant on the company making a profit, so your income is not guaranteed
- Dividends are paid after corporation tax has been deducted, while a salary is classed as a tax-deductible expense
- Any dividend not covered by profits becomes a director’s loan, which must be repaid
- Dividends are not seen as ‘relevant UK earnings’ under tax relief on pension contributions.
“There is no right or wrong answer when it comes to choosing a salary or dividend, as it depends on your personal circumstances,” adds Joanne. “Factors such as other income streams, maternity benefits, sick pay and profit forecasts will all play a part.
One thing is for sure: you will undoubtedly benefit from getting sound financial advice as early as possible. By creating a financial strategy for you and your business, you set a blueprint for your future earnings.
* Figures based on the tax year 2020-21