What is the optimum salary for a director?

It's common practice for directors of small businesses who are also the company owners to pay themselves a small salary and then take the rest of their income as dividends from the available profit. The reason is for tax efficiency. A company starts paying corporation tax from the first pound of profit and salaries being an expense, they reduce that profit. Dividends on the other hand are distributed after corporation tax of 20% (for small businesses) has been paid. The problem with salaries on the other hand is that they can be heavily taxed on the recipient and also they generate significant Class 1 National Insurance Contributions (12% for the employee and 13.8% for the employer). Thankfully Income Tax and NIC are only charged after you earn a certain amount per year.

From 6th April 2013 the rate at which you can pay a salary to an employee without suffering Income Tax and NIC will increase from £7,488 to £7,696 per annum. This is known as the Employers’ Earnings Threshold. If you have Limited Company and pay yourself a small salary then you should consider increasing the salary up to this threshold.

Paying up to the 2013/14 Employees’ Earnings Threshold of £7,755 provides a very small benefit of £5.29 (Corporation Tax saving at 20% less Employers NIC cost) compared to paying up to the Employers’ Earnings Threshold. However the extra administration of having to account for and arrange payment of the National Insurance is likely to outweigh any benefit. Paying up to the 2013/14 Income Tax personal allowance of £9,440 however results in an additional cost of £45.94 (Employers and Employees NIC cost less Corporation Tax saving at 20%) compared to the Employers Earning Threshold.

There are a number of calculators on the web that allow you to play with the different options. One of the best ones can be found on the NewBizAccountant website along with additional advice.

Update for 2014/2015: because of the new NIC allowance, the calculation is now somewhat different. Refer to our most recent article for updated numbers.