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 Should profits be withdrawn in the form of salary/bonus, as dividends or via company pension contributions?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.

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 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.

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:

* 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.

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.

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.

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.

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.