Salary Versus Dividends – Which is Best?

 In Contractors & Freelancers

Should You Pay Yourself with Salary or Dividends?

Wondering whether the time has come to incorporate as a limited company? First, you need to understand the difference between being paid by salary and by dividends. 

Many freelancers and contractors will eventually reach a point where they decide the time has come to form a limited company. The main reason to do this is to optimise their tax obligations. Recent developments do make this a little less appealing, but in many cases, this is a useful way to save some money. However, once you set up your company you need to decide how you will be paid and that means understanding the difference between salaries and dividends. 

Salary versus dividends

When you set up a limited company, you’ll become simultaneously an employee of the company who is entitled to a salary and a shareholder who is entitled to share dividends. This is important because dividends usually attract a slightly lower rate of tax. These are:  

  • Tax free dividend allowance: £2,000
  • Ordinary rate: 7.5% on earnings up to £37,500
  • Higher rate: 32.5% on earnings up to £150,000
  • Advanced rate: 38.1% on taxable income over £150,000

Salaries, meanwhile, are taxed differently. Everything under a minimum threshold is tax free, while everything above that level will be hit with an escalating level of tax of at least 20%. 

For 2019/20 the thresholds are as follows. 

  • Personal allowance: Incomes up to £12,500 pay 0%. 
  • Basic rate: From £12,501 to £50,000 you pay 20%.
  • Higher rate: £50,001 to £150,000 pays 40%.
  • Over £150,000 pays 45%.

Both dividend and income tax rates are set to stay unchanged for the 2020/21 tax year.

Unlike a dividend, salaries are subject to national insurance. All earnings between £9,500 and £50,000 are taxed at 12%. Beyond that, they are taxed at 2%. 

If you work as a limited company you will also have to pay 13.8% employers national insurance for all income above the secondary threshold of £8,632 per year. In 2020/21 this rises to £8,722.   

In recent times, however, the government has tried to make the practice less appealing. Increases to dividend tax were designed to reduce the benefits. Contractors have also been conspicuously left out of the financial support packages available to self employed people during the pandemic. However, you can still put yourself on furlough as an employee. 

If your spouse is also a shareholder in your limited company, you can also split your dividend income to reduce your combined tax liabilities and increase income. 

Where to set them?

The next question is: where to set them? In general, people will look to keep salaries low – as close to the personal allowance threshold as possible. 

For example, you could set your salary at the personal allowance threshold of £12,500 and take the rest through a dividend. For example, if you took £35,000 as a dividend, you’ll be paying the bulk of your income at just 7.5% rather than 20%.

There’s also another issue which high earners might have to consider. If your income as a contractor exceeds £100,000, your personal allowance starts to shrink. For every £2 over the £100,000 threshold you are paid, your personal allowance falls by £1. 

How an accountant can help

The rules can be a little complicated and they are moving all the time. With the Chancellor working out how to pay for the excesses lavished during the pandemic, 2021 could also see a number of changes to the way we all pay income tax. 

Fortunately, if you use an accountant, or outsource your tax to an accountancy firm, you will never have to get involved with them. A good accountant can take this particular worry off your shoulders and advise you on the optimal way to structure your income. As well as keeping all the details in order, this frees you up to concentrate on the more immediate challenges of driving your enterprise forward. 

The decision of whether or not to move from being a sole trader to a limited company can be a difficult one. They both come with their own advantages and disadvantages but understanding the real difference between dividend and salary income will help you decide on the best way forward.

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