Dividends or salary – which is best?
Mar 06, 2020
If you run your own limited company, chances are that you’ll be aware of dividends. These are payments made to company shareholders from the profits of a company, after all of the necessary business taxes have been paid.
Dividends are distributed according to the percentage of company shares which you own. So if you own half the shares, you should receive 50% of each dividend distribution.
The benefits of incorporating your business as a limited company and extracting your profits by way of dividends is that you don’t need to pay National Insurance Contributions (NICs) on dividends. This differs from salary payments, on which you must pay NICs both as an employer and as an employee.
How dividends are taxed
The rules for taxing dividends changed radically in April 2016, when a dividend nil rate band was introduced for UK residents and the previous 10% notional tax credit was removed. Now all taxpayers receive a dividend ‘allowance’, regardless of their marginal rate of tax. This dividend allowance is set to continue at £2,000 for 2020/21, and is over and above your personal tax allowance of £12,500.
This means that the first £2,000 of your taxable dividend income is taxed at a rate of 0%. Between £2,000 and the basic rate tax band (£50,000) your dividends are taxed at 7.5%, and then they are taxed at 32.5% up to the higher rate band (£150,000). Beyond that, if they fall into the additional rate band they will be taxed at 38.1%.
So, if you are a higher rate taxpayer and you received £22,000 of dividends in 2019/20, only £2,000 of those dividends are tax free. This means that the remaining £20,000 of dividends will be taxed at 32.5%, and you will owe £6,500 in tax – which will be due by 31 January self assessment deadline.
Although taking dividends can have its advantages over salary as the tax rates are lower, the most tax-efficient solution is often taking a combination of both. If you take a small salary you continue to accrue qualifying years towards your state pension. Plus, your salary counts as an allowable business expense, which then reduces the amount of Corporation Tax your company pays. It’s also worth remembering that a dividend can only be paid if there are sufficient retained profits in your company.
If you are a taxpayer and a shareholder in the family company, and you have not fully used your basic rate tax band for the current tax year, you may want to consider declaring a dividend. This is because shares in the family business can be transferred to your spouse or civil partner. So your spouse or partner can receive dividends to cover any remaining available personal allowance, dividend nil rate band and / or basic rate band.
How to choose between dividends and salary
If you’re unsure whether to go for dividends or salary, the best solution is to do some detailed calculations for the different scenarios. Look at your company profits, and apply either NICs and income tax, or corporation tax and dividend tax, to see which situation allows you to retain most of your profit.
There are however a variety of considerations to take into account, and so it’s worth consulting a tax expert to be certain you’re making the right decision. We’re always happy to chat through the best solution for your individual circumstances, so please feel free to give us a call.