Are you sure you’re paying yourself in the best way to reduce taxes? 

Many business owners in the UK unknowingly pay more tax than they need to, simply because they don’t know how to structure their income efficiently. 

Red Fish Accountancy is here to guide you through the complexities of tax-efficient salary options and dividend strategies to help you make the best decisions for your business.

Here are some of the most effective ways to pay yourself from your business and the tax considerations to keep in mind.

Exploring Tax-Efficient Compensation Strategies for Business Owners

As a business owner, the way you pay yourself can have a significant impact on the amount of tax you pay. 

Each approach comes with its own set of advantages and tax implications.

The Balance Between Salary and Dividends

When deciding how to pay yourself, the most common approach is to combine salary and dividends. This strategy allows business owners to take a small salary, which falls under the personal income tax allowance, and then take additional income through dividends. 

Dividends are typically taxed at a lower rate than salary, so it makes sense for many UK business owners to use this combination. 

This strategy can be a tax-efficient way to draw money from your business, but it’s important to ensure that you’re following all the correct regulations.

Dividends

Benefits of Paying Yourself with Dividends

Dividends are a common and tax-efficient way for business owners to pay themselves. 

Unlike salary, dividends are subject to lower tax rates and do not attract National Insurance contributions, which can make them a more cost-effective option.

As of the 2024/25 tax year, the tax rates for dividends in the UK are:

  • Basic Rate: 8.75%
  • Higher Rate: 33.75%
  • Additional Rate: 39.35%

It’s worth noting that the tax-free dividend allowance has been reduced to £500. Any dividend income above this allowance is taxed according to the rates above, depending on your total income for the year.

However, dividends can only be paid out of company profits after corporation tax has been deducted. The amount you pay yourself in dividends cannot exceed the company’s retained earnings. 

If your business does not generate enough profit, dividend payments are not a viable option.

Salary Payments and Their Tax Implications

Paying yourself a salary is the most straightforward way to draw money from your business. However, there are tax implications to consider, particularly when it comes to National Insurance contributions and income tax.

Setting a Tax-Efficient Salary Level

In the UK, the most tax-efficient salary for business owners is typically set at or just within the personal allowance threshold for income tax. For the 2024/25 tax year, the personal allowance remains £12,570. 

This means that you can earn up to this amount without paying income tax.

However, if your total income exceeds £100,000, the personal allowance decreases by £1 for every £2 earned above this threshold. Once your income surpasses £125,140, you lose the personal allowance entirely. This makes it important to carefully plan your salary if your earnings are within this range.

Keeping your salary within the personal allowance means you won’t pay income tax on it. It also keeps you eligible for state pension contributions and other National Insurance-related benefits. 

Earning more than this amount means paying income tax and National Insurance, which will increase your overall tax bill.

National Insurance Contributions and Their Impact

National Insurance contributions (NICs) are an important consideration when setting your salary. 

While a salary up to the personal allowance limit does not attract NICs, any amount above this threshold will. If you’re running your business as a limited company, you may choose to pay yourself a salary that falls within the NICs threshold to avoid additional costs. 

However, this could also impact the amount you contribute towards your state pension.

The Role of Dividends in Your Income Strategy

 While a salary is important for income, dividends provide another way to pay yourself, often with more tax efficiency. 

How Dividends Are Taxed Differently Than Salary

In the UK, salaries are taxed with income tax and National Insurance, while dividends are taxed at lower rates and only with dividend tax.

For salaries in 2024/25:

  • Income tax starts at 20% and can go up to 45% depending on how much you earn.
  • You also pay National Insurance (12% on earnings up to £50,270 and 2% above that).

Dividends are taxed as follows:

  • 8.75% for the first £50,000.
  • 33.75% between £50,000 and £150,000.
  • 39.35% above £150,000.

Dividends aren’t subject to National Insurance, making them more tax-efficient. But there’s a £500 tax-free allowance, so be careful not to exceed it.

Optimal Dividend Strategies to Maximise Take-Home Pay

The most tax-efficient way to take dividends is to keep your total income below the higher-rate tax thresholds. 

This means that you should combine salary payments (within the tax-free allowance) with dividends up to the point where you remain in the basic-rate tax band. If your business has made a profit, paying yourself a dividend can be a highly tax-efficient way of increasing your income without triggering higher tax rates. 

However, you should be mindful of the fact that dividend payments can only be made out of company profits, so this should be factored into your overall business planning.

Utilizing Business Structures to Your Advantage

The structure of your business plays a significant role in how you pay yourself. 

Choosing the right business structure, such as a sole trader or limited company, can help you maximise tax efficiency.

Limited Company vs Sole Trader: Tax Implications

If you’re a sole trader, you pay income tax on your profits and National Insurance contributions based on your earnings. 

Although operating as a limited company can provide tax benefits, especially when it comes to drawing income through a combination of salary and dividends. A limited company is a separate legal entity, which means you can pay yourself a salary and dividends from the company’s profits. 

This structure offers more flexibility in how you pay yourself and can result in significant tax savings, as dividends are taxed at a lower rate than salary income.

How Incorporation Can Save You Money on Taxes

Incorporating your business can help reduce your personal tax bill in several ways. As a limited company, you can pay yourself a low salary to stay within the personal allowance, then take dividends to make up the rest of your income. 

This approach helps you minimise the amount of salary that is taxed at higher rates and reduces your National Insurance contributions. 

Additionally, there are other tax advantages, such as claiming business expenses and reducing corporation tax. These benefits make incorporation an attractive option for many business owners who want to pay themselves in a tax-efficient way.

Tax Planning and Timing for Business Owners

Effective tax planning requires careful timing, particularly at the end of the financial year. 

Knowing when and how to manage your income can help reduce your taxable income and minimise your tax bill.

Importance of Year-End Tax Planning

Year-end tax planning is the perfect time to review your income, decide on the most tax-efficient way to pay yourself, and consider how to reduce your tax liabilities. 

For example, you might consider deferring income to the next tax year or increasing pension contributions to lower your overall taxable income. A bit of planning can go a long way in minimising taxes and keeping your business finances on track.

business team analysis

Strategies for Deferring Income and Reducing Taxable Income

One effective strategy for reducing your taxable income is deferring earnings. This means postponing some of your income to the next financial year. 

If you receive dividends or salary towards the end of the financial year, you could delay payment until the start of the new year to reduce your taxable income for the current year. 

Other strategies include increasing pension contributions, which can lower your taxable income while also benefiting your future retirement plans.

Pension Contributions as a Tax-Efficient Payment Method

Paying into a pension scheme is another way to reduce your taxable income. 

Pension contributions can be deducted from your earnings, which reduces your tax liability.

How Pension Contributions Reduce Your Tax Bill

Contributing to a pension scheme is a tax-efficient way to save for retirement and lower your current tax bill. Pension contributions are deducted from your earnings before tax, which means you pay less tax on your income. 

For instance, if you contribute £5,000 to your pension, your taxable income for the year will decrease by that amount, reducing your overall tax liability. 

Additionally, if you’re contributing to a personal pension, you typically receive tax relief. The standard rate of tax relief is 20%, meaning for every £80 you contribute, the government adds £20 (so the total contribution is £100).

The Benefits of Employer Contributions to a Pension Scheme

Employer contributions to pension schemes are a tax-efficient way to save for the future. 

If you run a limited company, contributions made by the company to your pension are tax-deductible as a business expense and are not subject to National Insurance contributions or income tax.

Types of Expenses You Can Claim

As a business owner, you can claim various business-related expenses, including office supplies, travel costs, and even a portion of your home office expenses if you work from home. 

These expenses can be deducted from your business’s profits, reducing the amount of tax your business has to pay. When claiming expenses, it’s important to keep accurate records and only claim what is legitimate, as HMRC has strict rules on what can and can’t be claimed.

Reimbursing Expenses: A Tax-Efficient Practice

Business expenses can often be used to reduce your tax liability. 

If you properly reimburse yourself for expenses, you can lower the amount of income that is taxed.

The Process of Claiming Business Expenses

Claiming business expenses is relatively straightforward. You need to keep receipts and records for all business-related purchases and submit them as part of your company’s annual accounts. These expenses can then be deducted from your profits, reducing the amount of tax you owe. 

It’s always a good idea to consult an accountant at Red Fish Accountancy to make sure you’re claiming everything you’re entitled to and following the correct procedures.

Tax Considerations for Business Vehicles and Equipment

If you use a vehicle or other equipment for your business, there are tax-efficient ways to account for these items.

Claiming Capital Allowances

Capital allowances allow businesses to claim 100% tax relief on qualifying assets up to the Annual Investment Allowance (AIA) limit of £1 million, such as vehicles or machinery. 

These allowances can be used to offset the cost of the asset against your business profits, which reduces the amount of tax you owe. 

The rules surrounding capital allowances can be complex, so it’s important to consult with an accountant to ensure you’re claiming the correct amount.

The Advantages of Leasing vs. Buying

The best option depends on your business’s cash flow and long-term needs, so it’s important to consider all factors before making a decision.

Leasing a vehicle or equipment for your business can provide tax advantages, as the lease payments are tax-deductible. However, if you buy an asset outright, you can claim capital allowances. 

Get the Most Tax-Efficient Salary Structure for Your Business

As a business owner in the UK, paying yourself the right way can make a huge difference in how much tax you pay. Whether you choose to pay yourself a salary, take dividends, or use other strategies like pension contributions and business expenses, there are several ways to reduce your tax liability. 

If you’re looking for practical advice to get your finances in shape, Red Fish Accountancy can guide you through the process and help you make the most of your income. 

Let us help you find the right approach to managing your business finances and lowering your tax liability. Get in touch today to see how we can help you.