Salary, dividend or pension contribution?
What is the optimum way for a shareholding director to extract money from their profitable private company: salary/bonus, dividend or pension contribution?
The shareholding directors of profitable private companies have constantly faced the question of how best to extract profits. It is an issue which often arises as their company’s year-end approaches. Should profits be withdrawn in the form of salary/bonus, as dividends or via company pension contributions? The decision is highly complex, with the underlying factors regularly changing. Salary/bonus or dividend will deliver an immediate payment to the recipient whereas the pension contribution will provide a deferred benefit. Any ‘profit extraction’ comparisons that include pension contributions can only be validly modelled if immediate funds are not required. If deferment is not an option, a comparison should only be between salary/bonus and dividend.
This briefing is not examining the director’s basic remuneration structure, but marginal increases to it. The issue of whether to incorporate and, if so, the base income mix of salary and/or dividend is a different one, albeit many similar factors are involved.
Before taking a closer look, let’s first examine some of the key issues to consider in relation to pension contributions.
Link between earnings and contribution limit
It is not necessary for a director to draw a salary to justify any employer pension contribution. However, any employer pension
contribution does need to pass the ‘wholly and exclusively for the purposes of the trade’ test if the company is to benefit from tax relief. From the director’s tax perspective, account also needs to be taken of the Annual Allowance, currently a maximum of £60,000, the associated carry forward provisions and the tapering rules.
Tax relief for employer contributions
Tax relief on an employer contribution depends upon the contribution being regarded by HMRC as paid ‘wholly and exclusively for the purposes of the trade’. However, in most cases, employers should not have any issues obtaining a deduction for corporation tax purposes for all employer pension contributions. HMRC’s Business Income Manual (BIM46005) confirms that ‘A pension payment by an employer is normally wholly and exclusively for the purposes of its trade.
Tax and NI contributions
The payment of either salary or bonus will be tax deductible for the paying company, unlike a dividend, but there will be income tax and national insurance to be allow for. Let’s consider NICs, first:
NI contributions are an important part in remuneration planning. Here are the key rates for 2024/25 and 2025/26:
| 2024/25 | 2025/26 | |
|---|---|---|
| Employer | 13.8% on earnings above £9,100 | 15.0% on earnings above £5,000 |
| Employee* | 8% on earnings between £12,570 and £50,270 | 8% on earnings between £12,570 and £50,270 |
| Employee* | 2% on earnings above £50,270 | 2% on earnings above £50,270 |
* Not payable once State Pension Age reached
Employment Allowance is an entitlement of £5,000 a year (£10,500 in 2025/26) for businesses, charities, and amateur sports clubs towards their employer (secondary) Class 1 NIC liability. It can be an important factor in profit extraction planning for shareholding directors, but often it will already have been used against the director’s and/or employee’s salary and bonuses.
The Employment Allowance cannot be claimed if the director is the only employee paid above the employer secondary Class 1 NIC threshold. However, if a company employs, for example, husband and wife directors where both earn above the threshold, the Employment Allowance is available. Please see HMRC’s guide Single-director companies and Employment Allowance: further guidance. This means that they could, for example, both take a salary of £12,570, to potentially use their respective personal allowances and reduce their NICs bill to £Nil by benefitting from the Employment Allowance. More information on the Employment Allowance for employers and how to claim can be found from the gov.uk website.
Dividends vs salary/bonus
The main advantage of dividends over salary/bonus is that dividends are not usually subject to national insurance. Some directors cannot avoid NI contributions by taking dividends though. This stems from the anti-avoidance provisions targeted at personal service companies (often referred to as IR35 or off-payroll working) which are now to be found in Part 2, Chapter 8 of ITEPA 2003. Directors caught by these provisions effectively must treat all their affected profits as earnings, even if they are paid as dividends. Further measures aimed at managed service companies were introduced in 2007 and are contained in Part 2, Chapter 9 of ITEPA 2003. Please see IR35.
As well as usually having a national insurance advantage over profit extraction by salary/bonus, dividends also offer a cash flow advantage. Dividends are normally paid out of post corporation tax profits and this is an important factor in profit extraction comparisons, the more so since the April 2023 increase in corporation tax rates for all but the smallest companies. However, the corporation tax on profits from companies with profits under £1.5m is not due until nine months and one day after the end of their financial year, whereas PAYE income tax is payable almost immediately. Other companies pay their corporation tax in quarterly instalments with the first payment due in the seventh month of the financial year for companies with £1.5m-£20m profits and the third month for £20m+ companies.
One further advantage of dividends against salary/bonus is that for any given net amount received by the director, their gross amount of dividend will be less than the gross salary/bonus. For example, to receive £5,000 net, a basic rate taxpayer requires £6,944 of salary/bonus but only £5,479 of dividend.
In some instances, this gross difference can tip the balance in favour of dividends when there are issues about total income, e.g. for tax rate thresholds or the high-income child benefit charge.
Bringing it to life
All of the following profit extraction comparisons are presented on the basis that the company will have first considered and discounted the reasons for and consequences of retaining profit within the company.
Before considering comparisons of the main methods of profit extraction it is worth considering the relative merits of retaining profits within the company.
Having considered some of the key factors for pension contributions, salary/bonus, dividends and corporate retention of funds, let’s look at some case studies comparing the profit extraction methods. The following represent some illustrative case studies. As will be appreciated, in “real life” each case will need to be considered on its own merits.
Case study 1
Teign Ltd is a one-person company, based in Somerset, with £40,000 of pre-tax profits, £20,000 of which is to be used for the benefit of its sole director, Alex. He currently receives a basic salary of £25,000 from the company, making him a basic rate (20%) taxpayer. He also has a small dividend income which already covers his dividend allowance. It is assumed that any pension contribution will be within the director’s Annual Allowance (after taking account of any available carry forward). The company pays corporation tax at 19% (i.e. the small profits rate):
| Salary 24/25 | Salary 25/26 | Dividend | Pension | |
|---|---|---|---|---|
| Gross profit | £20,000 | £20,000 | £20,000 | £20,000 |
| Pension contribution | Nil | Nil | Nil | £20,000 |
| Corporation tax @ 19% | N/A | N/A | (£3,800) | N/A |
| Net dividend | N/A | N/A | £16,200 | N/A |
| Employer NI * | (£2,425) | (£2,609) | N/A | N/A |
| Gross Bonus | £17,575 | £17,391 | N/A | N/A |
| Director NI – full rate ** | (£1,406) | (£1,391) | N/A | N/A |
| Director NI – lower rate ** | N/A | N/A | N/A | N/A |
| Income tax *** | (£3,515) | (£3,478) | (£1,418) | N/A |
| Benefit to director | £12,654 | £12,522 | £14,782 | £20,000 |
* 2024/25: £17,575 x 13.8% = £2,425.35 | 2025/26: £17,391 x 15.0% = £2,608.65
**2024/25: £17,575 x 8% = £1,406.00 | 2025/26: £17,391 x 8% = £1,391.28
*** For salary: 20% on all salary . For dividend: 8.75% on all dividends.
The relative advantage of taking benefits in the form of dividends rather than salary is because the saving in NI contributions more than counters the additional tax. The dividend also adds £1,375 (£1,191 in 2025/26) less to Alex’s gross taxable income than the salary option would.
Note that the Employment Allowance is not available to cover the NICs cost on Alex’s salary, as Alex is the sole director and has no employees.
It could be argued that the above comparison is unfair in relation to the pension contribution, as normally only up to 25% of the pension benefits can be taken tax-free by the director. If allowance were made for a PCLS of 25% it could be argued that the net benefit to the director will be £17,000 (i.e. (£20,000 x 25%) + (75% x £20,000 x 0.8)). There is also the obvious fact that if the director is under pension age they cannot immediately access the benefits from the pension arrangement.
Case study 2
Quay Ltd has £500,000 pre-tax profit and wishes to apply £20,000 of that profit for the benefit of one of its directors, Bob, an English resident higher rate (40%) taxpayer who already draws a salary of £89,000 from the company and has £1,000 of dividend income. It is assumed the pension contribution will be within the director’s Annual Allowance (after taking account of any available carry forward). The company pays corporation tax at 25% (i.e. the main profits rate):
| Salary 24/25 | Salary 25/26 | Dividend | Pension | |
|---|---|---|---|---|
| Gross profit | £20,000 | £20,000 | £20,000 | £20,000 |
| Pension contribution | Nil | Nil | Nil | £20,000 |
| Corporation tax @ 25% | N/A | N/A | (£5,300) | N/A |
| Net dividend | N/A | N/A | £15,000 | N/A |
| Employer NI * | (£2,425) | (£2,609) | N/A | N/A |
| Gross Bonus | £17,575 | £17,391 | N/A | N/A |
| Director NI – full rate ** | N/A | N/A | N/A | N/A |
| Director NI – lower rate ** | (£351) | (£348) | N/A | N/A |
| Income tax *** | (£8,545) | (£8,435) | (£6,063) | N/A |
| Benefit to director | £8,679 | £8,608 | £8,937 | £20,000 |
* 2024/25: £17,575 x 13.8% = £2,425.35 | 2025/26: £17,391 x 15.0% = £2,608.65
** 2024/25: £17,575 x 2% = £351.50 | 2025/26: £17,391 x 2% = £347.82
*** 2024/25 For salary: 40% on all salary plus an extra £3,787, representing lost personal allowance as total income is £107,575, £7,575 over the tapering threshold:
(£17,575 + £3,787) x 40% = £8,544.80
2025/26 For salary: 40% on all salary plus an extra £3,695, representing lost personal allowance as total income is £107,391, £7,391 over the tapering threshold:
(£17,391 + £3,695) x 40% = £8,434.40
For dividend: 33.75% on all dividends plus 40% on £2,500, representing lost personal allowance as total income is £105,000, £5,000 over the tapering threshold:
£15,000 x 33.75% + £2,500 x 40% = £6,062.50
The relative advantage of taking benefits in the form of dividends rather than salary is as a result of the dividend income being less than the bonus and therefore preserving more (£1,287 = £3,787- £2,500) of the personal allowance. This produces a tax saving of £514.80. Had Bob’s total income been £80,000 instead of £90,000 the tapering of the personal allowance would not have been an issue and the salary route would have been yielded the greater benefit. This underlines the importance of not just considering marginal tax rates, but also total income.
It is assumed that the Employment Allowance is used against other employee earnings or is otherwise unavailable. If the Employment Allowance is available, it would cover part of the employer NI cost on Bob’s basic salary.
Again, it could be argued that the above comparison is unfair in relation to the pension contribution, as normally only up to 25% of the pension benefits can be taken tax-free by the director. If allowance were made for a PCLS of 25% it could be argued that the net benefit to the director will be £14,000 (i.e. (£20,000 x 25%) + (75% x £20,000 x 0.6)). As for Case Study 1, there is also the obvious fact that if the director is under pension age they cannot immediately access the benefits from the pension arrangement.
Note that there must be sufficient profits to pay the illustrated level of dividends to all equivalent shareholders.
Case study 3
Bishop Ltd has £150,000 pre-tax profit and wishes to apply £20,000 of that profit for the benefit of one of its directors, Drew, who already has a salary of £60,000, dividend income of £750 and is an English resident higher rate (40%) taxpayer. It is assumed the pension contribution will be within the director’s Annual Allowance (after taking account of any available carry forward). The company pays corporation tax at 26.5% on this £20,000 of profit (i.e. the marginal profits rate):
| Salary 24/25 | Salary 25/26 | Dividend | Pension | |
|---|---|---|---|---|
| Gross profit | £20,000 | £20,000 | £20,000 | £20,000 |
| Pension contribution | Nil | Nil | Nil | £20,000 |
| Corporation tax @ 25% | N/A | N/A | (£5,300) | N/A |
| Net dividend | N/A | N/A | £15,000 | N/A |
| Employer NI * | (£2,425) | (£2,609) | N/A | N/A |
| Gross Bonus | £17,575 | £17,391 | N/A | N/A |
| Director NI – full rate ** | N/A | N/A | N/A | N/A |
| Director NI – lower rate ** | (£351) | (£348) | N/A | N/A |
| Income tax *** | (£7,030) | (£6,957) | (£4,961) | N/A |
| Benefit to director | £10,194 | £10,086 | £9,739 | £20,000 |
* 2024/25: £17,575 x 13.8% = £2,425.35 | 2025/26: £17,391 x 15.0% = £2,608.65
** 2024/25: £17,575 x 2% = £351.50 | 2025/26: £17,391 x 2% = £347.82
*** For salary: 40% on all salary. The personal allowance is unaffected | For dividend: 33.75% on all dividends
It is assumed that the Employment Allowance is used against other employee earnings or is otherwise unavailable. If the Employment Allowance is available, it could cover part or all the NIC cost on Drew’s salary.
Again, the relative advantage of taking benefits in the form of salary rather than dividends is because the corporation tax bill more than outweighs the NIC costs and extra income tax liability of salary.
If the same argument about the pension comparison is made, it could be argued that the net benefit to the director will be £14,000 (i.e. (£20,000 x 25%) + (75% x £20,000 x 0.6)) if the director pays 40% marginal income tax in retirement. As for the other case studies, there is also the obvious fact that if the director is under pension age they cannot immediately access the benefits from the pension arrangement.
In this example, the difference between salary and dividend would be narrowed or even eliminated if Drew has children and is the higher income partner of a couple claiming child benefit. In that instance, the higher total gross income generated by extra salary than dividend translates into a greater high income child benefit charge.
Conclusion
In closing it is essential to re-state that each case should be considered on its own facts before deciding
- Whether to extract profits; and if so
- How?
Advice is essential.
As these case studies have underlined, it is dangerous to apply a rule of thumb for when comparing dividends or salary because of tripwires such as the Employment Allowance, tapering personal allowance and HICBC. Ultimately there is no substitute for case-by-case calculations.
With that important caveat in mind, the table below is a starting point in comparing the dividend/salary choice outside of Scotland for 2024/25 and 2025/26. The differing earnings and dividend thresholds between Scotland and the UK make a Scottish table only possible in three tax rate dimensions – corporation tax, income tax and dividend tax.
| 19% Corporation tax rate | 25% Corporation tax rate | 26.5% Corporation tax rate | |
|---|---|---|---|
| 20% Income tax rate | Dividend | Dividend | Dividend |
| 40% Income tax rate | Dividend | Salary | Salary |
| 45% Income tax rate | Dividend | Salary | Salary |
This information is for UK financial adviser use only and should not be distributed to or relied upon by any other person.
Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given.
