There’s a moment every contractor has when they land their first proper client contract, the invoice is sent, and the payment hits their shiny new business bank account. It feels amazing. But then comes the next thought, how do I actually get this money out of the company and into my personal account… without getting destroyed by tax?
When I started ContractorPal Ltd, I made the classic newbie mistake, I figured I’d just pay myself whatever I needed and sort out the details later. What I didn’t realise was that paying yourself tax-efficiently is one of the biggest differences between working smart and working stressed. If you do it right, you can save thousands a year and still stay totally above board with HMRC. Do it wrong, and you’ll either overpay or invite a nasty letter through your letterbox.
So, let me show you what I’ve learned about paying yourself properly, the real-world way that works for most UK contractors running their own limited companies.
How Contractors Typically Earn Through Their Company
As a limited company director, you’re in a unique position. You’re both the employer and the employee. That gives you flexibility over how you take money out of the business. Most contractors use a mix of salary and dividends, and once you understand why that works, everything starts to click.
Salary is straightforward. You pay yourself a wage through PAYE, just like any other employee. It comes with tax and National Insurance, but it also builds up qualifying years for your state pension and gives you access to benefits like maternity pay or sick leave.
Dividends are where the real tax savings often lie. These are paid from profits after the company has paid its Corporation Tax. They’re not subject to National Insurance, and they’re taxed at a lower rate than salary once you pass your personal allowance. It sounds too good to be true, but it’s totally legit, if done properly.
The Most Tax-Efficient Salary for Directors (2025/26)
Every tax year, there’s a sweet spot where your salary is low enough to avoid Income Tax and employee National Insurance, but high enough to qualify for state pension and benefits. For 2025/26, that salary is £12,570, right in line with the personal allowance.
At that level, you don’t pay Income Tax, and you just about scrape under the threshold for employee National Insurance. The company still has to pay a bit of employer’s National Insurance on that amount, but it’s usually worth it for the personal tax savings and National Insurance record.
I pay myself this amount monthly via PAYE, and it ticks all the boxes. It keeps things simple, builds up my state contributions, and lets me draw the rest of my income as dividends.
Dividends: The Secret Sauce (But With Rules)
Dividends are where the bulk of your income as a contractor can, and usually should come from. After your company pays its Corporation Tax on profits, you’re allowed to pay out the remaining profit to shareholders. If you’re the only shareholder, that’s you. If you’ve split shares with a spouse or partner, you can divvy it up between the two of you.
In 2025/26, the first £500 of dividend income is tax-free. Yes, it’s dropped again. But after that, you’ll pay 8.75% if you’re in the basic rate band, 33.75% in the higher rate band, and 39.35% in the additional rate.
This is still significantly lower than what you’d pay on equivalent salary income, especially when you factor in National Insurance. That’s why dividends are so popular. But they’re not a free-for-all. You can only pay dividends out of retained profits, and you need to create proper paperwork, board minutes, dividend vouchers, the lot. If you skip those formalities, HMRC can reclassify your income as salary and backdate the tax.
Why You Can’t Just Take All Your Money as Dividends
I know it’s tempting. Just skip the salary bit and pay yourself entirely through dividends to dodge National Insurance, right? That’s what I thought when I started. But it doesn’t work like that.
HMRC expects directors to pay themselves a reasonable salary, and if they see you taking large, regular dividends without any salary at all, that can raise a red flag. Worse still, if you’re ever caught under IR35 or involved in a tax investigation, the lack of PAYE payments could be used against you.
Besides, not paying yourself a salary means missing out on those all-important state pension years. It’s a false economy in the long run. The most tax-efficient approach is about balance, not avoidance.
What About PAYE and National Insurance?
When you run payroll for your director’s salary, your company becomes an employer. That means you’ll need to register for PAYE with HMRC, file monthly returns (even if there’s only one employee, you), and pay employer National Insurance contributions.
It sounds like a hassle, but most contractor accountants include this as part of their monthly package. I don’t even think about it anymore, my accountant runs payroll automatically, submits the reports, and tells me what to transfer.
The good news? Employer NICs are deductible for Corporation Tax, so the hit isn’t as bad as it looks. Plus, paying yourself this way makes everything look professional and keeps your company compliant.
How to Split Income for Maximum Efficiency
This is where everything comes together. Once you’ve set your salary at that optimal level, enough to tick HMRC’s boxes without triggering extra tax, the rest of your income should usually come from dividends. But the split isn’t random. It depends on how much profit your company actually has after tax, how much you need to live on, and whether you’ve already hit any personal tax thresholds.
In my first year, I tried to keep it simple. I paid myself a salary of just over £1,000 a month, that £12,570 annual sweet spot. Then, each quarter, once I’d paid Corporation Tax and covered my business expenses, I worked out how much profit was left. That’s what I took out as dividends. I didn’t touch every last penny, I always left a buffer in the company for future bills, taxes, or a quiet spell between contracts.
Doing it this way gave me consistency in my personal income without putting pressure on the company’s cash flow. And because the salary and dividends were clearly documented, I had no issues come tax time. Everything lined up, my accountant was happy, and so was HMRC.
Using a Spouse or Civil Partner to Lower the Tax Bill
Here’s a little trick that’s 100% legal and surprisingly underused, income splitting with your spouse or civil partner. If your partner is in a lower tax band, or not using their personal allowance at all, you can make them a shareholder in your limited company and share dividends between the two of you.
It’s not about dodging tax; it’s about making the most of the allowances you’re both entitled to. For example, if you’re already pushing into the higher rate band, and your partner is under the basic rate threshold, splitting dividends can save you thousands in tax over the course of a year.
Of course, it has to be done properly. Your partner needs to actually own the shares, and they must receive the dividends. It can’t just be on paper. But set it up right, and it’s one of the smartest ways to legally reduce your joint tax bill without stepping into dodgy territory.
What If You’re Inside IR35?
Ah, IR35, the tax law that haunts every contractor eventually. If your contract is caught inside IR35, you can’t use the salary and dividend strategy. All income from that engagement has to be paid through PAYE, with full Income Tax and National Insurance.
This usually means going through an umbrella company or having your end client or agency deduct the taxes before paying you. There’s very little room for flexibility here, and it completely takes the wind out of the dividend strategy.
That’s why it’s so important to have your contracts reviewed and make sure you understand your IR35 status for every job. If you’re outside IR35, great, you’ve got options. But if you’re inside, you need to play by a different set of rules. Mixing strategies between inside and outside contracts during the year can get messy, so keep things clean and track them separately.
Pension Contributions: The Overlooked Strategy
If you’re not already using your limited company to make pension contributions, you’re leaving money on the table. I didn’t pay much attention to pensions early on, I figured I’d sort that out later. But once I realised the tax advantages, it became one of my favourite ways to pay myself more, while paying HMRC less.
Here’s how it works. Your company makes contributions directly into your pension. These payments are a business expense, so they reduce your Corporation Tax bill. And because they’re going straight into your pension, you don’t pay Income Tax or National Insurance on them either.
The contributions don’t count as salary or dividends, they’re completely separate. And the limits are generous, especially if you’ve got unused allowance from previous years. It’s not immediate money in your pocket, but it’s still your money, growing, tax-free, for your future. Once I got my head around that, I started making regular contributions every year.
Company Expenses You Can Claim to Reduce Tax
Another way to keep more of what you earn is by claiming legitimate business expenses. This doesn’t mean stretching the rules or trying to sneak personal items into your accounts. It means understanding what costs are genuinely “wholly and exclusively” for business, and making sure you claim them.
In my case, I claim home office use, business travel, accountancy fees, software subscriptions, and even part of my phone bill. If it helps me do the job or run the company, and I’ve got the receipts to back it up, it’s going through the books. Every expense reduces your taxable profit, which means a smaller Corporation Tax bill, and more money left over for dividends or reinvestment.
When You Should Leave Money in the Company
It’s tempting to take out every pound the business earns, especially in a good year. But there are times when it’s smarter to leave money in the company. Maybe you’re planning a quiet quarter, or you’ve got a big tax bill coming up. Maybe you’re pushing close to the higher rate tax threshold personally, and pulling more out now would just cost you more in tax.
Leaving profits in the company keeps your options open. You can use that money to invest in growth, pay a future dividend when your tax band allows, or just build a financial cushion. I’ve done all three, depending on the year. It’s one of the perks of being your own boss, you control the timing.
FAQs About Contractor Pay and Tax Strategy
Wondering if you can backdate a dividend? You can’t, once the tax year ends, that ship has sailed. Curious if you need to pay yourself every month? Not necessarily, but regular payments help with budgeting and HMRC likes consistency. Thinking about skipping salary altogether? I wouldn’t, for all the reasons we’ve covered.
These are the kinds of questions I get asked all the time, and the answers always come back to the same idea: plan ahead, keep it clean, and talk to a good accountant. There’s no one-size-fits-all strategy, but the foundations are the same for everyone.
Be Smart, Not Sneaky—HMRC Isn’t Stupid
Paying yourself tax-efficiently isn’t about finding loopholes or gaming the system. It’s about knowing the rules, using them to your advantage, and staying honest throughout. HMRC has seen every trick in the book, and they’ve closed most of them. But they still allow legitimate, fair, and smart strategies for people who run their own companies responsibly.
I’ve made mistakes. I’ve overpaid. I’ve underpaid and had to sort it out later. But every year I get a bit better at balancing salary, dividends, expenses, and pensions in a way that works for me. And if you take the time to understand your own position and build a plan that fits your business, you’ll never look at payday the same way again.