The salary and dividend question comes up in almost every conversation with a new owner-managed business client. Not because the principle is complicated, but because the detail is surprisingly easy to get wrong, and the consequences of getting it wrong tend to be quiet at first and then costly when someone finally looks closely.
Most directors operating through a limited company have a broadly correct instinct: pay yourself a modest salary and take the rest as dividends, because dividends are taxed more lightly than employment income. That instinct is sound in principle. The trouble is in the execution. The salary is often set at an arbitrary figure. The dividends are taken as the company bank account permits rather than as the retained profit position supports. The director’s loan account accumulates entries that nobody quite understands. And then April arrives and the numbers do not quite add up.
This guide works through the decision in the order it actually needs to be made, from the salary level through to dividend policy and the one structural trap that catches more directors than any other.
What you will learn:
- Why the optimal salary level changed materially from April 2025, and what that means for your payroll
- How to decide whether to take salary to the personal allowance or hold it lower
- What the dividend allowance is now and how dividend tax is calculated for basic and higher-rate directors
- What the director’s loan account is, why it becomes a problem, and how to prevent it
Start with the salary decision
The salary decision for an owner-director is not the same as a salary decision for an employee. You are choosing the level, which means you need to understand what each possible level actually costs and what it buys you.
For most owner-directors operating through a company where they are the only employee, the question turns on two thresholds: the Lower Earnings Limit and the point at which employer’s National Insurance becomes payable. In 2025/26, the Lower Earnings Limit is £6,500 a year. Paying yourself at or above this level through payroll means you earn a qualifying year for State Pension purposes, even though no National Insurance contributions are actually due at that level. Below it, the year does not count. For directors who are some way from State Pension age and have gaps in their record, this matters.
The employer’s National Insurance threshold changed significantly from April 2025. The secondary threshold, above which your company pays employer’s NI, dropped from £9,100 to £5,000. The rate also increased, from 13.8 per cent to 15 per cent. This means that if your company pays you a salary above £5,000 a year, it is paying employer’s NI on the excess at 15 per cent, with no employee NI payable until the salary reaches £12,570.
The Employment Allowance, which can offset up to £10,500 of employer’s NI liability, sounds relevant here but is not available to companies where the only employee is also the sole director. If your company has other employees on the payroll, the position is different and the allowance may make a higher director salary significantly cheaper.
The three salary levels most directors consider
- £5,000: No employer or employee NI. Below the Lower Earnings Limit, so no NI qualifying year. Simple, but costs you a State Pension credit.
- £6,500 (Lower Earnings Limit): Earns a qualifying State Pension year. Employer NI of approximately £210 applies on the excess above £5,000. Often the most sensible choice for sole-employee companies.
- £12,570 (personal allowance): Uses the full personal allowance in salary, no income tax on the salary itself. No employee NI. Employer NI of approximately £1,135. Relevant if your company has other staff and can use the Employment Allowance to cover it.
In each case, the salary is deductible against corporation tax, which reduces the net cost. At the 19 per cent small profits rate, a £1,000 salary costs the company £810 after the corporation tax saving. At the main 25 per cent rate, it costs £750. That deductibility matters when you are comparing the cost of paying salary against simply leaving the money in the company.
There is no universally correct answer. The right salary depends on your company’s corporation tax rate, whether you have other employees on the payroll, your personal State Pension position, and whether your personal allowance is being used elsewhere. What matters is that you have made the decision deliberately, based on those factors, rather than because the number felt approximately right.
Then think about dividends
Dividends are a distribution of post-tax profit. They are not a salary substitute or a drawing mechanism. The distinction is important, because it affects both when you can take them and how they are taxed.
A dividend can only be paid out of retained distributable profits. If your company does not have sufficient retained profit to support the payment, the dividend is unlawful, and the amount taken becomes a director’s loan, which has its own tax and timing consequences. This is one of the most common structural problems in owner-managed businesses, and it usually develops gradually: the director takes money when they need it, the bookkeeper records it as a dividend, and nobody checks whether the profit position actually supports it until the accounts are prepared.
The dividend allowance in 2025/26 is £500. That is the amount of dividend income a taxpayer can receive free of additional tax, on top of any unused personal allowance. It has fallen sharply over the years, from £5,000 in 2016/17, and it is worth noting that the allowance does not mean the first £500 is untaxed entirely. It means no dividend tax is payable on that slice, but the income still counts toward the thresholds for higher-rate and additional-rate tax.
Above the allowance, dividends are taxed at 10.75 per cent within the basic rate band, 35.75 per cent within the higher-rate band, and 39.35 per cent for additional-rate taxpayers. These rates are lower than the equivalent income tax rates, which is why dividends remain a tax-efficient form of extraction when the company has distributable profits and the director is a basic-rate taxpayer. For higher-rate taxpayers, the advantage narrows considerably, and the tax planning question becomes more nuanced.
A director earning £50,000 from a combination of salary and dividends, all within the basic-rate band, will typically pay less in combined income tax and National Insurance than a director drawing the same amount entirely as salary. The difference is meaningful, but it is smaller than it once was, and it disappears above £50,270 where the higher-rate dividend tax rate applies.
Advisory observation, Xeinadin Richmond
Build a dividend policy, not just dividend habits
The phrase ‘dividend policy’ sounds formal for a business run by one or two people, but the underlying idea is simply this: before you take a dividend, check that the company can afford it. That means looking at the retained profit position, not just the bank balance.
The bank balance and the retained profit figure are not the same thing. The bank account includes money that is owed to HMRC for VAT and corporation tax, money that may be needed for upcoming payroll, and money that reflects timing differences in creditor and debtor balances. None of that is available for distribution. A director who takes dividends based on what is sitting in the current account, rather than what the profit and loss position supports, will eventually find themselves with a director’s loan account problem.
A practical approach is to run a simple quarterly review. Look at the year-to-date profit after tax, subtract any dividends already paid, and treat the remaining distributable profit as your available pool. If you want to be conservative, hold back a buffer for the corporation tax liability that has not yet crystallised. What is left is what the company can distribute without creating a loan account entry.
For directors who want a more regular income rather than irregular lump sums, it is entirely possible to pay a consistent monthly dividend as long as the profit position is reviewed and the payment is properly minuted. Dividends do not have to be taken sporadically. They just have to be lawful when they are taken.
The director’s loan account trap
The director’s loan account is a record in the company’s books of money owed between the director and the company. When a director takes more money from the company than has been allocated as salary or declared as a dividend, the excess sits in the loan account as a debt owed by the director to the company. An overdrawn director’s loan account is not simply a bookkeeping entry. It has real tax consequences.
If the director’s loan account is overdrawn at the company’s year end and is not repaid within nine months of that date, the company faces a Section 455 tax charge of 33.75 per cent on the outstanding balance. That charge is refundable once the loan is repaid, but it is a cash flow problem in the meantime, and the interest charge HMRC requires on loans above £10,000 adds further cost. Our guide to cashflow under pressure explains why maintaining visibility on your drawings position matters.
The loan account problem typically develops when there is no clear distinction between what the director is taking as salary, as dividends, and as reimbursements for expenses. Everything goes in and out of the company account, and the categories are tidied up at year end rather than maintained throughout the year. By the time the accountant sits down with the figures, the loan account may already be overdrawn by a significant amount, and the options for clearing it before the nine-month deadline are limited.
Prevention is straightforward in principle: keep salary, dividends, and expenses reimbursements as separate, identifiable transactions. Declare dividends formally with a board minute and dividend voucher at the time of payment, not retrospectively. And check the loan account position quarterly rather than discovering it annually.
When the structure needs revisiting
The salary and dividend combination that worked well when the company was making £80,000 a year may not be optimal when it is making £180,000. As profit grows, more income falls into the higher-rate band, which changes the relative efficiency of dividends versus other forms of extraction. Pension contributions become an increasingly important part of the picture, because employer pension contributions reduce the company’s taxable profit without creating a personal income tax liability for the director at the time of payment.
Life changes also affect the calculation. A director who has a spouse or civil partner who is a shareholder in the company may be able to spread dividend income across two personal allowances and two basic-rate bands, which can reduce the household tax bill substantially. This structure needs to be set up correctly to withstand scrutiny, including genuine shareholding and appropriate dividend entitlement, but it is a legitimate and commonly used approach for Richmond families where one partner has lower personal income.
The threshold at £100,000 also deserves attention. Above that point, the personal allowance begins to be withdrawn, creating an effective 60 per cent marginal rate that catches many business owners by surprise. For a director whose salary and dividends are likely to push them above £100,000 in a given year, pension contributions or dividend timing across the tax year boundary can materially reduce the liability.
Key takeaways
- The optimal director salary depends on whether you have other employees and can access the Employment Allowance. For sole-employee companies, the Lower Earnings Limit of £6,500 is often the right starting point.
- Dividends can only be paid out of distributable profit. Taking money because it is in the bank account is not the same as taking a lawful dividend.
- The dividend allowance is now £500. Dividends above that are taxed at 10.75 per cent (basic rate), 35.75 per cent (higher rate), or 39.35 per cent (additional rate).
- An overdrawn director’s loan account at year end, something easily monitored through cloud accounting, triggers a Section 455 tax charge of 33.75 per cent on the balance unless repaid within nine months.
- As profit grows and circumstances change, the salary and dividend structure should be reviewed, not left to run on the same settings indefinitely.
Frequently Asked Questions
Can I change my salary mid-year?
Yes, a director’s salary can be changed at any point, but the change should be documented by a board resolution and the payroll updated accordingly. Making the change retrospectively, particularly upward, creates risk.
Does my dividend need to be the same for all shareholders?
Dividends are typically paid on a per-share basis, meaning all shareholders of the same class receive the same rate per share. If you want to pay different amounts to different shareholders, you either need different classes of shares, which requires careful setup, or you make a payment to one shareholder that is not a dividend at all, which changes the tax treatment entirely.
What if my company has made a loss this year?
You cannot pay a dividend if the company does not have sufficient distributable reserves to support it. You may be able to draw on accumulated retained profits from previous years, but this depends on the overall balance sheet position. If historic reserves have been wiped out by current-year losses, there is nothing available to distribute and any amounts taken are a director’s loan.
Should I be paying myself more salary and less dividends now that the employer NI threshold has dropped?
Not necessarily. The drop in the secondary threshold increases the cost of a higher salary for sole-employee companies, which if anything makes the lower salary approach more attractive for that group. For companies with other staff and access to the Employment Allowance, the calculus is different. This is precisely the kind of question that warrants a brief conversation with your adviser rather than a general answer.
Do I need a board minute every time I pay a dividend?
Yes, in principle. A dividend is a formal distribution of profit, and it should be accompanied by a board resolution approving the payment and a dividend voucher stating the amount, the date, and the shareholder receiving it. For a sole director company this feels bureaucratic, but it is a legal requirement, not a formality. If HMRC investigates and you cannot produce records showing when dividends were declared and on what basis, the payments may be treated as something other than dividends, which changes the tax position considerably. Keeping a simple template and completing it at the time of each payment takes minutes and removes a significant compliance risk.
Can I backdate a dividend?
No. A dividend takes effect on the date it is declared, and a dividend voucher or board minute dated after the fact does not change when the income arose for tax purposes. Backdating is a common temptation at year end, when directors or their bookkeepers try to tidy up the loan account position by declaring dividends retrospectively to cover amounts already taken. HMRC is alert to this, and if the declared date does not match the payment date or the available profit at the time, the dividend is likely to be challenged. The only reliable approach is to declare dividends at the time they are paid, with the profit position checked in advance.
When do I actually pay tax on my dividends?
Dividend income is reported through self assessment and the tax is due by 31 January following the end of the tax year in which the dividends were paid. For directors who have not filed a self assessment return before, this can come as a surprise, particularly if a significant amount was taken in dividends during the year and no payments on account were made. The first year is often the most uncomfortable, because the January bill covers the full year’s liability plus the first payment on account toward the following year, which can mean a combined payment of 150 per cent of the annual liability landing at once. Getting ahead of this by estimating the liability during the year and setting money aside avoids a cash flow shock.
Will taking dividends affect my mortgage application?
Yes, and this is one of the most practically significant consequences of the salary and dividend structure that directors in Richmond encounter. Most high street lenders assess affordability based on salary and dividends combined, but the way they calculate that varies considerably. Some lenders will take salary plus dividends in the most recent year. Others average two or three years. Some weight salary more heavily and apply a lower multiple to dividend income. If your drawings have been inconsistent, or if you took lower dividends in a year when the business was under pressure, the income figure a lender will use may be materially lower than what you are currently earning. If a remortgage or a property purchase is on the horizon, it is worth speaking to both your accountant and a mortgage broker who works with self-employed and company director clients before you apply, rather than after a lender has made an assessment that does not reflect your actual position.
Can my spouse receive dividends if they do not work in the business?
This is possible, but it requires careful structuring and it is not without limits. If your spouse or civil partner holds shares in the company, they are entitled to receive dividends on those shares, and those dividends are taxed at their personal rates rather than yours. In households where one partner has little or no other income, this can be a legitimate and tax-efficient arrangement. The risk arises under the settlement legislation, which HMRC can use to attribute income back to the working spouse if the arrangement looks like a device to divert income rather than a genuine shareholding. The courts have considered this area a number of times, and the tests are not always clear cut. If your spouse or partner is a genuine participant in the business, even informally, the arrangement is more defensible. If they have no connection to the business at all, the structure warrants careful advice before you put it in place.
Should I be thinking about pension contributions alongside dividends?
Almost certainly, yes. Employer pension contributions made by your company are deductible against corporation tax and do not form part of your personal income at the time of payment, so they are not subject to income tax or dividend tax when made. For directors whose income is already pushing into the higher-rate band, or who are approaching the £100,000 threshold where the personal allowance begins to be withdrawn, employer pension contributions can be one of the most efficient ways to extract value from the company while reducing the overall tax charge. The annual allowance limits how much can be contributed in any one year, and higher earners should be aware of the tapered annual allowance which reduces the limit for those earning above £200,000. This is an area where the interaction between company and personal tax planning makes a joined-up conversation with your adviser particularly worthwhile.
If this feels like a conversation worth having
The salary and dividend split is one of those areas where a 30-minute annual review tends to save considerably more than it costs. If your current structure has not been looked at in the past couple of years, or if your profit levels have changed materially, it is worth taking the time to check that the numbers still make sense.
The team at Xeinadin Richmond works with owner-managed businesses across Richmond and South West London on exactly this kind of practical planning. There is no obligation in getting in touch, and no pressure to do anything other than make sure the right decisions are in place.
About the Author
Donovan Crutchfield, ACA – Area Managing Partner, Xeinadin Richmond.
Donovan Crutchfield is Area Managing Partner at Xeinadin Richmond and founder of TaxAgility. He is ACA-qualified and has worked with owner-managed businesses, professionals and growing SMEs across Richmond and South West London for many years. His practice focuses on helping business owners make clear, well-informed decisions, particularly in areas where the rules are less straightforward than they first appear.
Connect with Donovan on LinkedIn.
Xeinadin Richmond is part of Xeinadin Group, one of the UK’s leading networks of independent accountants and business advisors. Visit our Richmond office page.
