Strategies for combining director salary and dividends


Working as contractor, freelancer or small business owner through a limited company, you would have been told and have read that the most tax efficient way to withdraw money from your company is to a take a small salary (up to your personal tax allowance) and the remainder via dividends.

However, changes to the way that dividends are taxed, may not make this the best option for everyone, anymore.

In this article, we look at what is the most tax efficient salary and dividend combination for limited company directors for the tax year 2017/18.

How dividends used to be taxed

Prior to April 2016, dividends came with something called a dividend ‘tax credit’.

Dividends were entered onto the company’s account net but declared as gross on the director’s personal tax return with the 10% ‘tax credit’ attached to it.

An example of how this worked:

  • £9,000 dividend was declared on the company’s accounts
  • his was grossed up by 10% to £10,000 for the directors’ personal tax return
  • If the total taxable income (including gross dividend) was below the higher rate threshold (£42,385 for 15-16), you didn’t have to pay any additional tax
  • If the total taxable income was above the higher rate threshold, then dividends that fell into this band were taxed at 22.5% (for gross dividend) or 25% (for net dividend)

Dividend rules after April 2016

The, then, chancellor, George Osbourne announced plans that from 6 April 2016 tax paid on dividends was to be ‘simplified’. The dividend ‘tax credit’ was abolished and it was replaced with a tax-free dividend allowance of £5,000.

Any dividends above £5000 are taxed as follows:

Tax band Dividend tax rate
Basic 7.5%
Higher 32.5%
Additional 38.1%

This means that a director can have a tax-free income of £16,500 for the tax year 2017/18 (£11,500 from the personal tax allowance plus £5,000 from the tax-free dividend allowance).

Alternative methods

The following strategies assume that you want to keep your taxable income within the basic tax band (£45,000 for 17/18).

Strategy 1 – claiming employment allowance (if the company meets the criteria laid out by HMRC)

Things to consider:

The employment allowance was introduced in 2014 and it means that employers do not have to pay the first £3,000* of their employees’ national insurance.

From the tax year 16/17 companies with only one employee (i.e. a director) are not eligible to claim the employment allowance.

From what we can see, it seems ok for a husband – wife run company to claim the employment allowance. However, this could change and we recommend you speak to us first to check that this is still stands.

How it works:

  • Director takes a salary of £11,500 (which means no personal income tax is due)
  • Employees national insurance of £400 is due
  • No employer national insurance is due (this is covered by the employment allowance)
  • As you are staying within the basic tax band, dividends will be taxed at 7.5%


Gross salary £11,500
Dividends £33,500 (£45,000 – £11,500)
Total gross income £45,000
Employee national insurance £400
Dividend tax £2,138 (£33,500- £5,000 x 7.5%)
Net income £42,462

Strategy 2 – using National Insurance threshold

Things to consider:

This strategy may be a better option for companies that are not eligible to claim the employment allowance, or who are looking to keep it simple in terms of paperwork.

National Insurance threshold explained:

  • Lower earnings limit: if you earn above this limit you are protecting your entitlement to receive the state pension and other benefits in the future, without having to pay additional National Insurance
  • Primary threshold – above this threshold (£167 p/w or £8,164 p/a for 17/18) you must start paying National Insurance

The example below assumes that you want to claim a gross income up to the Primary threshold.


Gross salary £8,164 (leaving £3,336 of personal tax allowance)
Dividends £36,836 (£45,000 – £8.164)
Total gross income £45,000
Employee national insurance £0
Dividend tax £2,138 (£36,836 – £8,336* x 7.5%)
Net income £42,863

*£8,336 is made of the £3,336 of personal tax allowance left over, plus the £5,000 tax free dividend allowance.

As you can see, by using strategy 2 your net income is higher than strategy 1 by £401. However, this does not take into consideration the additional corporation tax you save on the gross salary in strategy 1.

Comparison of strategy 1 & 2

£ Annual
Strategy 1 Strategy 2
Gross salary £11,500 £8,164
Dividends £33,500 £36,836
Total gross income £45,000 £45,000
Employee national insurance £400
Dividend tax £2138 £2138
Net income £42,462 £42,683
Corporation tax saved on gross salary £2185 £1551

Overall, strategy 2 is the better option for limited company directors, as it gives them a higher net income even though it costs them more in corporation tax. It also has the added benefit of less paperwork as no employee national insurance is due to HMRC.

Tax planning tips

We’ve listed our top tax planning tips to ensure you are operating in the most efficient manner. We advise you to contact us first before implementing any of these ideas to make sure they are suitable for your company set-up:

  • Add your spouse as a director of the company or as a shareholder to utilise the dividend allowance
  • Claim your home as an office expense
  • Set up a pension through your company to reduce both corporation tax and dividend tax
  • A tax advance may be gained by paying your spouse a salary. That way, the company has two employees and can utilise the employment allowance.
  • Invest extra retained earnings in Enterprise investment schemes or SEIS. The downside is that the money will be stuck in the scheme for three years.
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Shams Urrehman
MD Accounts Direct

Hi, I'm Shams Urrehman, Qualified accountant since 2005 and Director at Accounts Direct Ltd since 2009. I have been advising freelancers, management consultancies, IT contractors, SME’s and other businesses about accounts and tax planning.

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