Salary vs Dividend – it pays to explore your options

Exchange Accountants explains the importance of finding that all-important ‘sweet spot’

One of the fundamental decisions that business owners and company directors in Northern Ireland need to make is how they want to be paid.

The two primary methods of extracting income from your business are salary and dividends – and understanding the implications of each is crucial for optimising your overall income and tax position while remaining compliant with relevant regulations.

Whether you go down the salary or dividend route, or find a ‘sweet spot’ between the two, could save thousands of pounds per year for business owners and directors across Northern Ireland, according to Conor Walls, Director at Lisburn-based digital accountancy specialist Exchange Accountants

“One of the perceived major benefits of owning your own business or being a director in the company is the ability to extract profits from the company by way of dividends,” explained Conor.

“This opens up options in terms of how you are paid, whether that be via salary or dividend – each with its own advantages and disadvantages – or a mixture of both which is often the best way forward. 

“Salaries provide stability and your National Insurance contributions (NICs), deducted from your salary, entitle you to certain state benefits. Importantly, these are deducted from company profits before corporation tax is calculated.

“The fact that no NICs are payable on dividends means that, in many cases, taking dividends may well result in the overall  tax and National Insurance burden than taking a salary payment. However, it must be remembered that dividends can only be paid if there are sufficient retained profits in the business and, unlike salaries, are taken after corporation tax has been deducted,” he added.

“There are a lot of factors to consider and every individual’s circumstances will be different, so it’s important to weigh up all the pros and cons and seek guidance from qualified professionals to ‘crunch the numbers’ and craft an income strategy that perfectly aligns with your individual circumstances and optimises benefits for your business.

“Finding that ‘sweet spot’ between salary and dividend payments can literally save individuals thousands of pounds every year,” concluded Conor. 

Taking all of this into account, the team at Exchange Accountants has summarised the key aspects of salary and dividend payments, comparing the two and providing insights, to help business owners and directors make informed decisions.

Exchange Accountants – Understanding the Pros and Cons of Salaries vs Dividends

What is Salary?

A salary is a fixed regular payment made by an employer to an employee in exchange for work or services rendered. It is typically paid monthly, and the amount is predetermined and agreed upon as part of the employment contract. When you pay yourself a salary, you become an employee of the company, and National Insurance contributions and income tax are deducted at source from your salary.

Pros of Salary:

1. Stability and predictability: With a salary, you have a consistent income stream, making financial planning and budgeting more straightforward.
2. State pension and benefits: Paying National Insurance contributions entitles you to certain state benefits, such as the State Pension, Statutory Sick Pay, and Maternity Pay.
3. Credibility and mortgage applications: A regular salary can enhance your credibility when applying for mortgages or other forms of credit.
4. Ability to make larger pension contributions that will attract tax relief: The higher your PAYE salary, the higher the ceiling for pension contributions that will attract tax relief. You can receive tax relief on up to 100% of your PAYE salary – up to a maximum of £60,000 per annum.

Cons of Salary:

1. Higher tax liability: Salary income is subject to National Insurance contributions (for both the employee and the employer) and income tax, which can result in higher overall tax liability compared to dividends.
2. Limited tax planning opportunities: With salary income, tax planning options are relatively limited, leaving fewer opportunities to optimise your tax position.
3. Employer responsibilities: If you are an employer, paying yourself a salary involves additional responsibilities, such as Pay As You Earn (PAYE) reporting and compliance with employment regulations.

What are Dividends?

Dividends are payments made to shareholders of a company out of the profits or retained earnings of the business. Unlike salaries, dividends are not fixed and can vary depending on the company’s financial performance and the decision of the directors. As a shareholder, you are entitled to receive dividends in proportion to your shareholding.

Pros of Dividends:

1. Tax efficiency: One of the significant advantages of dividends is their favourable tax treatment. In many jurisdictions, dividends are subject to lower tax rates than salaries, potentially resulting in tax savings.
2. Tax planning flexibility: Dividends offer more tax planning opportunities, allowing you to time dividend payments strategically to optimise your tax liability.

Cons of Dividends:

1. Profit dependency: Dividends are contingent on the company’s profitability. During lean periods or loss-making years, the payment of dividends may not always be feasible.
2. No National Insurance contributions: Dividends do not attract National Insurance contributions. While this can be an advantage in terms of reduced tax liability, it may have implications for your entitlement to certain state benefits.
3. Irregular income: Unlike salaries, dividend income can be irregular and dependent on the company’s financial performance.

Which is Better: Salary or Dividend?

The answer to this depends on your specific circumstances and financial goals. Many business owners choose a combination of salary and dividends to achieve the most tax-efficient and financially beneficial outcome.  Consider the following factors when deciding on your preferred income mix:

1. Personal financial needs: Assess your personal financial requirements and determine the level of income you need to cover your living expenses and achieve your financial objectives.
2. Tax implications: Understand the tax implications of both salary and dividend income including respective rates of income tax, corporation tax and NICs.
3. State benefits and pension: Consider the impact of your income type on your eligibility for state benefits and your future entitlement to the State Pension.
4. Company performance: Evaluate your company’s financial performance and assess whether it can sustain dividend payments alongside essential operational expenses and growth initiatives.
5. Shareholding structure: The distribution of shareholding among directors and shareholders may influence the most tax-efficient income mix for the company as a whole.
6. Personal risk tolerance: Consider your tolerance for risk, as salary income provides greater stability compared to the variable nature of dividends.

Compliance and Legal Considerations:

When deciding on your income mix, it is crucial to adhere to all relevant tax laws and company regulations. Paying yourself dividends must comply with company law requirements, such as maintaining sufficient distributable profits and adhering to any restrictions outlined in the company’s Articles of Association.

Conclusion

In summary, the choice between salary and dividends involves a careful consideration of various factors, including personal financial needs, tax implications, company performance, and risk tolerance. Striking the right balance between the two can lead to optimal financial outcomes while ensuring compliance with legal and tax requirements and you should always take professional advice before making any decisions.

Exchange Accountants was established in 2011 and provides premier accountancy services and tax advice to a wide variety of locally based SMEs and individuals. 

Exchange was the first accountancy practice in Northern Ireland to be recognized as a Xero Gold Partner – and in 2021, the company achieved Platinum Partner status with the market-leading cloud accountancy software provider. 

For more information on Exchange’s digital accountancy and tax support services, contact us today.