If you’re a director of a limited company, deciding how to pay yourself—through salary, dividends, or both—is an important financial choice. This decision affects how much money you take home, how much tax you pay, your National Insurance contributions (NICs), and your company’s profits. Picking the right balance can help you save on taxes, while the wrong choice could mean paying more than necessary.
A salary is a set amount of money paid through the Pay As You Earn (PAYE) system, which means it is taxed, and NICs must be paid. Salaries also count as a business expense, which lowers the company’s taxable profits, but they come with extra costs for both the director and the company. Dividends, on the other hand, are payments made from company profits after tax has already been paid. They are taxed at lower rates than salaries, but they don’t count as a business expense and can only be taken out if the company has enough profit.
It’s important to understand the pros and cons of both options to manage taxes and keep your finances stable. In this article, the accountants Howlader & Co. will explain how salaries and dividends are taxed, their benefits and downsides, and how directors can find the best mix to save on taxes while keeping their company financially secure.
Understanding Salary and Dividends
When running a limited company, directors can pay themselves through salary, dividends, or a combination of both. Understanding how each method works is essential for tax efficiency and financial planning.
A salary is a regular payment made in exchange for work, processed through the Pay As You Earn (PAYE) system. This means it is subject to income tax and National Insurance contributions (NICs). Salaries are considered a business expense, reducing the company’s taxable profit and lowering corporation tax liability. However, higher salaries can lead to increased NICs for both the director and the company.
Dividends, on the other hand, are payments made from the company’s post-tax profits. Since they are not classified as wages, dividends do not attract National Insurance contributions, making them a more tax-efficient way to extract profits. However, dividends are not tax-deductible for the company and can only be distributed if there are sufficient retained earnings. They are taxed separately from salaries at lower rates but can still contribute to an individual’s overall tax liability.
Many directors opt for a combination of salary and dividends to optimize tax efficiency. A lower salary ensures eligibility for certain state benefits, while dividends provide a more tax-friendly income stream. The right balance depends on factors such as personal tax thresholds, company profitability, pension contributions, and overall financial goals.
Tax Implications of Salary
Salaries paid to directors of a limited company are subject to Pay As You Earn (PAYE), meaning they are taxed in the same way as employee wages. This includes income tax and National Insurance contributions (NICs), both of which affect the director’s take-home pay and the company’s payroll costs.
Income Tax on Salaries
Salary payments are taxed according to standard income tax bands in the UK:
Personal Allowance
Up to £12,570 – tax-free.
Basic Rate
20% on income between £12,571 – £50,270.
Higher Rate
40% on income between £50,271 – £125,140.
Additional Rate
45% on income over £125,140.
National Insurance Contributions (NICs)
Directors earning a salary above the Lower Earnings Limit (£6,396 per year) qualify for state pension benefits without paying NICs. However, NICs become payable once the salary exceeds certain thresholds:
Employee NICs (Class 1)
10% on salaries above £12,570.
Employer NICs
13.8% on salaries exceeding £9,100.
Employers must pay NICs on salaries above this threshold, making high salaries more expensive for the company.
Business Expense & Pension Considerations
One advantage of taking a salary is that it qualifies as a business expense, reducing the company’s corporation tax liability. Additionally, salaries count toward pension contributions, which can be beneficial for long-term financial planning.
When to Take a Higher Salary
A director may choose to take a higher salary if:
- They require a steady income.
- They want to maximize state pension entitlements.
- They need a higher salary to secure a mortgage or loan.
However, due to NICs and tax, many directors opt for a low salary combined with dividends to minimize tax liability while retaining benefits.
Tax Implications of Dividends
Dividends are a popular way for limited company directors to extract profits because they are taxed at lower rates than salaries and are not subject to National Insurance contributions (NICs). However, dividends can only be paid if the company has sufficient post-tax profits—meaning profits left after corporation tax has been deducted.
How Dividends Are Taxed
Dividend income is taxed separately from salary and falls under specific tax bands. For the 2024/25 tax year, the rates are:
Dividend Allowance
The first £500 of dividend income is tax-free.
Basic Rate
8.75% on dividends up to £50,270 (including salary and other income).
Higher Rate
33.75% on dividends between £50,271 – £125,140.
Additional Rate
39.35% on dividends over £125,140.
Unlike salaries, dividends do not count as a business expense and therefore do not reduce corporation tax liability
Impact of Taking Large Dividends
While dividends are tax-efficient, taking large dividend payments can push directors into higher tax bands, increasing personal tax liability. If a director’s total income (salary + dividends) exceeds £100,000, their personal allowance is gradually reduced, increasing their effective tax rate.
Additionally, large dividends can:
- Increase student loan repayments, as they count toward total taxable income.
- Affect child benefit eligibility, if total income exceeds £50,000.
- Complicate mortgage applications, as some lenders prefer salaried income over dividends.
Balancing Dividends with Other Income
To minimize tax liability, many directors spread dividends across tax years or combine a low salary with dividends to remain within lower tax brackets. Careful tax planning ensures they maximize take-home pay while avoiding higher tax rates.
Pros and Cons of Salary
Pros of Taking a Salary
✔ Steady and Predictable Income – A salary provides a regular income, making it easier to budget for personal expenses, mortgage applications, and financial planning.
✔ National Insurance Benefits – A salary above the Lower Earnings Limit (£6,396 per year) qualifies directors for state pension contributions and other benefits like maternity allowance.
✔ Tax-Deductible for the Company – Salaries are considered a business expense, reducing the company’s taxable profit and corporation tax liability.
✔ Pension Contributions – Salary payments allow directors to contribute to workplace pensions or self-invested personal pensions (SIPPs), which can offer tax relief.
Cons of Taking a Salary
✖ Higher Income Tax Rates – Salaries are taxed according to PAYE rates, with income over £12,570 subject to 20% tax, increasing to 40% or 45% at higher thresholds.
✖ Employer National Insurance Costs – Companies must pay 13.8% Employer NICs on salaries above £9,100, increasing the cost of paying a higher salary.
✖ Reduced Take-Home Pay – Compared to dividends, salaries result in lower net income due to income tax and NICs.
Due to these downsides, many directors opt for a low salary (around £12,570) to maintain tax efficiency while still qualifying for state benefits.
Pros and Cons of Dividends
Pros of Taking Dividends
✔ Lower Tax Rates – Dividends are taxed at 8.75% (basic rate), 33.75% (higher rate), and 39.35% (additional rate), which is lower than income tax rates on salaries.
✔ No National Insurance Contributions (NICs) – Unlike salaries, dividends are not subject to employee or employer NICs, reducing overall tax liability.
✔ Flexible Payment Structure – Directors can choose when to withdraw dividends, allowing for better tax planning and optimization of personal tax thresholds.
✔ Efficient Profit Extraction – Dividends allow directors to take income from the company in a more tax-efficient manner, particularly when combined with a low salary.
Cons of Taking Dividends
✖ Only Payable from Post-Tax Profits – Dividends can only be distributed if the company has retained profits, making them unreliable if the business is not consistently profitable.
✖ Tax on Higher Dividend Earnings – Large dividends push directors into higher tax bands, resulting in tax rates up to 39.35%.
✖ Impact on Mortgage Applications – Some lenders do not view dividends as stable income, making it harder to secure a mortgage or loan compared to a salary.
Due to these factors, most directors take a combination of salary and dividends to maximize tax efficiency while maintaining financial stability.
Finding the Right Balance
Many limited company directors use a combination of salary and dividends to maximize tax efficiency while ensuring a steady income. A well-structured approach helps minimize income tax, National Insurance contributions (NICs), and corporation tax liabilities.
A common strategy is to take a salary up to the personal allowance (£12,570 for 2024/25). This level of salary is tax-free, qualifies directors for state pension contributions, and stays below the NIC primary threshold, avoiding employee NICs. Although employer NICs apply to salaries over £9,100, small businesses can offset this cost with the £5,000 Employment Allowance, if eligible.
The remainder of a director’s income can then be taken as dividends, which are taxed at lower rates than salaries. To stay within the basic tax bracket, a director might take dividends up to £37,700 (keeping total income below £50,270). This ensures dividends are only taxed at 8.75%, avoiding higher tax bands.
For example, a director earning:
£12,570 salary (tax-free)
£37,700 dividends (taxed at 8.75%)
would pay significantly less tax than if the entire amount were taken as salary.
Conclusion
Choosing between salary and dividends is a key financial decision for company directors, impacting taxes, take-home pay, and business profitability. By finding the right balance, directors can maximize tax efficiency while ensuring financial stability for both themselves and their company.
