PAYE vs Dividends: How Tax Codes Work for Directors Taking a Low Salary

If you own your own limited company, you have probably heard the golden rule of tax planning: Dividends can be used to compensate low-income pay. It sounds simple enough, but as the 2026/27 tax year approaches, the “simple” calculation has become a little more complicated.

With frozen personal allowances, diminishing dividend tax-free buckets (now only £500), and the complexities of HMRC tax laws, getting your compensation structure wrong might mean the difference between a thriving business and an unintentional donation to the Treasury.

But how does your tax code, that hidden string of numbers such as 1257L, react when you switch from a monthly PAYE salary to a quarterly dividend draw? Does a low salary mean that you are missing out on your State Pension, or are you simply being “tax-efficient”?

In this post, we will go over the processes of PAYE vs. dividends approach for 2026, explain how your tax code works behind the scenes, and help you find the “sweet spot” that makes both your bank account and the taxman happy.

Why Directors Often Take a Low Salary and Dividends

When you interact with most UK company directors, you will notice a common pattern: they pay themselves a modest salary through PAYE and then receive the balance portion of their earnings as dividends.

This isn’t random; it’s a deliberate tax planning strategy.

• To Use the Personal Allowance Efficiently: Every person in the UK is entitled to a Personal Allowance (about £12,570). Many directors set their salaries at or around this threshold in order to:
  • Use the tax-free allowance.
  • Maintain a qualifying year for the state pension.
  • Avoid paying needless income taxes.
    This guarantees they can extract some income without incurring additional tax liabilities.

• To Reduce National Insurance Contributions (NICs): Employee and employer national insurance contributions are deducted from salaries. Dividends are not. Directors can greatly cut by keeping their salaries low and accepting extra money as dividends.
  • Employer NIC (paid by the company)
  • Employee NIC (paid personally)
    This can create meaningful savings over the course of a year.

• Dividends Are Taxed Differently: Dividends are paid from corporate profits after Corporation Tax has been subtracted. They are taxed at dividend tax rates, which are often lower than ordinary income tax rates. This means that the salary-plus-dividend combination is more tax-efficient than accepting the entire income as salary.

• Cash Flow Flexibility: Unlike salaries, which are typically paid monthly, dividends can be announced at intervals that are appropriate for the company’s profitability and cash flow. This allows directors to manage personal income while also focusing on business performance.

How PAYE Works for Company Directors?

• Directors Are Employees Under PAYE:
  If you pay yourself a salary, your company must:
  • Register as an employer with HMRC
  • Run payroll (even if it’s just for you)
  • Submit Real Time Information (RTI) reports
  • Deduct Income Tax and National Insurance (if applicable)
    Your tax code is issued by HMRC and applied to your director’s salary just like any other employee.

• Directors Have a Special NIC Calculation Method: Directors’ NIC is typically calculated cumulatively over the tax year, as opposed to normal employees’ NIC, which is calculated per pay period (weekly or monthly).
  This means:
  • NIC is assessed based on total annual earnings
  • Adjustments may happen later in the year
  • Early low salary months may show no NIC, but it can change if pay increases
    This is why director payroll may appear different from usual employee payroll.

• Your Tax Code Still Applies: Even if you intentionally choose a low salary (for example, around the Personal Allowance threshold), your tax code will determine how much of it is tax-free.
  If your tax code is:
  • 1257L – You usually receive the full Personal Allowance.
  • 0T or BR – You may lose your tax-free allowance on salary.
  • K code – Extra tax may be collected through payroll.
    An incorrect tax code can reduce your take-home salary unnecessarily.

• Dividends Are Not Processed Through PAYE:
  Dividends are not processed through payroll and are unaffected by your tax code. Dividends are declared separately from profits and taxed on your self-assessment tax return. If you’re looking to understand how to register and file correctly, our guide on Online Tax Return Registration for First-Time UK Taxpayers walks you through the process step by step.

What Your PAYE Tax Code Means When You Take a Low Salary

When you go from a standard salary to a director’s mix of low pay and dividends, your tax code is usually 1257L for the financial year 2026/27. It becomes the “gatekeeper” of your take-home pay. Here’s what happens when you play the “Low Salary” game:

• The “Free Pay” Shield: The numbers in your code (£1257) represent the amount of money you can earn before paying any income tax.
  • If your salary is £12,570, your tax code is “fully used.” Because your allowance fully covers your wages, your monthly payslip will reflect £0.00 in income tax.
  • If you earn £5,000, you have £7,570 in “unused” allowance. This is necessary because the remaining shield can be used to offset your dividends, making a portion of them tax-free.

• The Dividend “Top-Up” Logic: HMRC has a strict “ordering” rule. They add your Personal Allowance to your pay first, then your dividends.
  • Important for 2026: Even if you have used all your Personal Allowance, you still have a separate Dividend Allowance of £500. This is a “0% band” that sits on top of your other earnings.

• When Your Tax Code Changes (K Codes & T Codes): If you have additional income, such as a company car, a medical perk, or unpaid tax from the previous year, HMRC may lower your code (e.g., 900L) or even assign you a K Code.
  
  A “K” Code indicates that your “benefits” outweigh your allotment. In this instance, HMRC basically regards you as having negative free pay, and you’ll begin paying tax on your first pound of wages.
  
  A K code can be a surprise for a director earning a modest salary because it can result in a tax liability on a salary that you thought was “too low to be taxed.”

How Dividends Are Taxed for Limited Company Directors?

Dividends are one of the most tax-efficient methods to pay yourself as a limited company director in the UK, but only if you understand how they are taxed.

Let’s break it down clearly.

• Dividends Are Paid From Profits (After Corporation Tax): Before you receive dividends, your company must:
  • Make a profit
  • Pay Corporation Tax on those profits
  • Have retained earnings available for distribution
    
    This means that dividends are paid from post-tax profits, whereas salaries are a business expense. If you’re unsure what costs your company can legally deduct, read our detailed guide on Claiming Allowable Expenses in the UK.

• Dividend Allowance (Tax-Free Threshold): Each tax year, directors get a Dividend Allowance.
  • For the 2025/26 tax year: £500 of dividends are tax-free.
  • This allowance applies in addition to your Personal Allowance (if available).

• Dividend Tax Rates (2025/26): Once you exceed your tax-free thresholds, dividends are taxed at:
  • Basic Rate (8.75%)
  • Higher Rate (33.75%)
  • Additional Rate (39.35%)
    The rate you pay depends on your total income (salary + dividends + other income).

• How It Works in Practice: The majority of limited company directors follow a common structure:
  • Take a small salary(often around the Personal Allowance threshold).
  • Take the rest as dividends. Dividends are not subject to NIC, hence this minimises National Insurance contributions (NICs).
    
  • Example:If you take:
    • £12,570 salary
    • £30,000 dividends
      
      You will pay:
    • No income tax on salary (if within Personal Allowance)
    • No NIC on dividends
    • Dividend tax only on the amount above the £500 allowance, and after using the basic rate band. Therefore:
      
  • Step 1: Salary Tax Position
    • £12,570 uses your Personal Allowance
    • Income tax: £0
    • Employee NIC: £0
    • (Assuming no other income)
      
  • Step 2: Dividend Allowance
    • Dividend allowance: £500
    • Tax-free dividends: £500
    • Taxable dividends: £30,000 − £500 = £29,500
      
  • Step 3: Apply the Basic Rate Band
    • Basic rate band: £37,700
    • Since £29,500 falls fully within the basic rate band, it is all taxed at the basic dividend rate.
      
  • Step 4: Dividend Tax Due
    • Basic rate dividend tax: 8.75%
    • £29,500 × 8.75% = £2,581.25 dividend tax
      
  • Final Tax Summary
    • Salary tax: £0
    • NIC on dividends: £0
    • Dividend tax payable: £2,581.25

• Dividends Must Be Properly Declared: You must:
  • Issue a dividend voucher
  • Record board meeting minutes
  • Ensure sufficient retained profits
  • Report dividends in your Self Assessment tax return
    
    Improperly declared dividends can be reclassified as salary, triggering PAYE and NIC liabilities.

PAYE vs Dividends – A Side-by-Side Tax Comparison

Limited business directors typically receive income in the form of a PAYE salary and dividends. Both generate money in your pocket, but they are taxed differently and serve different functions in tax planning.

Here’s an easily understood comparison of how PAYE and dividends work in practice:

Criteria	PAYE Salary	Dividends
Who can take it?	Any employee or director	Shareholders only
Taxed how?	Income Tax via PAYE	Dividend tax
National Insurance (NI)	Employee NI + Employer NI	No NI Payable
Tax-free allowance	Uses Personal Allowance (£12,570 if available)	Uses Dividend Allowance (£500 in 2026/27)
Tax rates (basic band)	20% income tax + NI	8.75% dividend tax
Payroll required?	Yes (RTI submissions)	No payroll
Impact on tax code	Directly linked to tax code	Indirect (via Self Assessment)
Timing flexibility	Fixed(monthly/weekly)	Flexible (when declared)

When Directors Must Register for Self Assessment

Most limited company directors must register for Self Assessment, particularly if their income is not completely taxed under PAYE.

You must register if:

• You take dividends from your company
• You have rental, foreign, or other untaxed income (landlords should also be aware of upcoming MTD requirements – see our guide on MTD by HMRC for Landlords & Sole Traders)
• Your total income exceeds £100,000
• You owe Capital Gains Tax
• HMRC sends you a Notice to File

If you are registering for the first time, you must do so by October 5th, following the end of the tax year.

Common PAYE and Dividend Mistakes Directors Make

Many limited company directors aim to keep things simple; they just take a portion of the salary and the rest as dividends. However, without appropriate planning, little mistakes can result in significant tax consequences. Here’s a more detailed explanation of the most prevalent faults and why they matter.

• Paying Dividends Without Checking Profits: Dividends can only be paid from available post-tax profits.
  Some directors:
  • Withdraw money regularly
  • Treat it like a personal draw
  • Don’t check retained earnings first
    
    If there are insufficient profits, the dividend becomes illegal. HMRC can reclassify it as a wage or a director’s loan, resulting in unexpected tax and penalties.

• Treating Dividends Like Tax-Free Income: Dividends are not tax-free. They are taxed at lower rates than salary, but they still count toward your total income.
  Many directors forget to:
  • Set aside money for dividend tax
  • Include dividends in their Self Assessment
  • Consider how dividends affect tax bands
    
    This often results in a surprise tax bill in January.

• Not Registering for Self Assessment: If you receive dividends, you are normally required to file a personal tax return. Some directors assume that their company’s accountant handles everything. However, corporation accounts and personal tax returns are separate. Missing registration or filing deadlines results in an automatic £100 penalty, even if no tax is payable.

• Accidentally Moving Into a Higher Tax Band: Dividends are added to your total income.
  If you:
  • Increase dividends late in the year
  • Don’t monitor total income
    
    You may unknowingly move from:
  • Basic rate → Higher rate (40% – see how to plan and Avoid 40% Tax UK)
  • Higher rate → Additional rate
    
    This significantly increases dividend tax.

• Poor Dividend Documentation: Each dividend payment should have:
  • Board minutes approving it
  • A dividend voucher
  • Proper accounting records
    Without documentation, HMRC may challenge the payment during an enquiry.

What Is the Most Tax-Efficient Mix for Directors Today?

For the financial year 2026/27 (starting April 6, 2026), the “sweet spot” for most UK company directors remains a combination of low salary and substantial dividends. However, recent budget adjustments, especially an increase in dividend tax rates and a lower threshold for Employer National Insurance (NI), have slightly changed the equation.

The general view on the best tax-efficient combination is as follows:

The “Sweet Spot” Strategy:

Most directors’ ideal salary is £12,570 per year, with any remaining profit distributed as dividends.

• Salary: £12,570 (aligned with the Personal Allowance and Primary NI Threshold).
• Dividends: Up to £37,700 (to stay within the Basic Rate band).
• Total Income Potential: £50,270 (£12,570 salary + £37,700 dividends)
  
  • Why this works:
    • Personal Allowance: At £12,570, you pay £0 in Income Tax.
    • Employee NI: This matches the Primary Threshold, so you pay £0 in Employee National Insurance.
    • State Pension: This is above the Lower Earnings Limit (£6,708 for 2026/27), ensuring you earn a qualifying year for your State Pension without actually paying personal NI.
    • Corporation Tax Savings: While the company will pay Employer NI on the portion of salary above £5,000, the salary is a tax-deductible expense. The Corporation Tax saved (at 19%–25%) usually outweighs the NI cost.

How E2E Accounting UK Helps Directors Get PAYE, Dividends, and Tax Codes Right

E2E Accounting UK assists limited company directors by ensuring that PAYE is properly set up, payroll is compliant, and all HMRC submissions are made on schedule. They strike the appropriate balance between compensation and dividends to maximise tax efficiency while remaining within legal restrictions.

Before declaring dividends, accountants verify available profits and establish suitable documents to avoid illegal dividend risks. Also study tax rules, process Self Assessment files, and offer proactive year-end tax preparation. What will be the outcome? Fewer surprises, a lower chance of penalties, and a transparent, compliance remuneration scheme.

Conclusion

The goal for UK limited company directors is not to choose between PAYE and dividends; rather, to effectively structure both. Your salary dictates how your tax code applies your Personal Allowance, but dividends enable you to gain post-tax profits more efficiently due to lower tax rates and no NICs.

However, with frozen allowances, a decreased £500 dividend allowance, and more powerful HMRC compliance, poor planning can result in larger tax bills, penalties, or unlawful dividends. The best tax-efficient technique is typically a balanced mix: a little income to safeguard allowances and State Pension eligibility, supplemented by correctly declared dividends, all reassessed before year-end to keep within tax brackets and remain fully compliant.

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