How to structure salary and dividends when incorporating a sole trader to minimise tax and maintain pension contributions

When a sole trader incorporates, one of the first and most impactful decisions is how to split remuneration between salary and dividends. I see business owners agonise over this — partly to minimise tax, partly to keep pension contributions and state-protecting National Insurance (NI) credits in place. In this article I’ll walk you through the practical choices I recommend, the trade-offs to consider, and a simple worked example so you can see the mechanics. I’ll also flag the admin and compliance you can’t ignore.

Why salary and dividends matter

In a limited company, you’re usually both a director and a shareholder. That means you can be paid in two main ways:

• Salary – treated as employment income, subject to PAYE, Income Tax and National Insurance contributions (both employee and employer), and counts as pensionable earnings for workplace pensions.
• Dividends – paid from company profits after corporation tax, taxed at dividend tax rates on the recipient’s personal tax return, and not subject to National Insurance.

The optimal mix depends on goals: minimise overall tax and NI, preserve or build state and workplace pension entitlements, and keep company cashflow healthy. The “classic” small-company approach is to take a modest salary (enough to use personal allowance or to secure NI credits) and take the rest as dividends. But it’s not one-size-fits-all.

Key considerations before you set a split

• Current thresholds change — Personal Allowance, NI thresholds and dividend allowances change periodically. Always check HMRC or ask an accountant before finalising figures.
• State pension and NI credits — If you want qualifying years for the state pension, you may need to pay sufficient Class 1 NI or ensure you have credits via another route. Salary levels (or voluntary NI payments) affect this.
• Pension contributions — Employer pension contributions are tax-deductible for the company and avoid NICs; employee contributions receive tax relief via payroll or self-assessment. Employer contributions don’t reduce your entitlement to dividends directly but reduce company profits available for dividends.
• Cashflow and retained profits — Dividends can only be paid from retained, distributable profits. If you extract too much too soon you risk creating an illegal dividend situation.
• Auto-enrolment — As an employer you must comply with workplace pension duties. Directors can sometimes be treated differently for auto-enrolment if they qualify as "only director" or are excluded, but this needs careful assessment and record-keeping.

Typical salary strategies and their implications

Here are the common approaches I discuss with clients.

• Salary up to personal allowance — Pay a salary equal to your personal allowance so you pay no Income Tax on that salary. You still pay employer NI if the salary is above the secondary threshold; employee NI depends on the primary threshold. This approach is straightforward and keeps tax low, but may not trigger sufficient NI contributions for state pension unless salary is high enough.
• Salary up to the NI lower/primary threshold — A lower salary (around the primary threshold) can avoid employee NI and may still secure NI credits if treated correctly. Directors’ NI is calculated differently for PAYE so check which threshold protects state pension credits. This is a common choice when keeping NICs minimal is a priority.
• Minimal salary + higher dividends — Minimises employer and employee NI, and increases use of lower-taxed dividend income. Good for cash extraction when company profits are healthy and you don’t need large pensionable earnings. The downside: lower pensionable earnings for workplace pension schemes and potential gaps in NI contributions for state benefits.
• Higher salary + employer pension contributions — Pay a higher salary to build pensionable earnings or trigger higher pension contributions, then supplement with employer contributions which are corporation tax efficient and avoid employee NI. This is often the best route for directors prioritising pension savings.

Pension contributions — employee vs employer

Pension rules are a powerful lever when you want to save tax and boost retirement savings.

• Employer contributions – Paid directly by the company, treated as an allowable business expense and reduce corporation tax. They aren’t subject to employer or employee NI, so they’re very tax-efficient. If your business can afford it, making employer contributions is often the most effective way to save for retirement and reduce company tax exposure.
• Employee contributions – Paid from net pay; you receive tax relief either through payroll (net pay arrangements) or via self-assessment for relief at source schemes. Employee contributions still attract NI on the salary they’re taken from unless you use salary sacrifice.
• Salary sacrifice – Swapping part of salary for employer pension contributions reduces the employee’s taxable pay and both employer and employee NI liabilities. It’s a popular option but must be agreed in writing and implemented through payroll correctly.

To maintain workplace pension entitlements and make the most of tax relief, I often recommend clients prioritise a mix of modest salary plus regular employer pension contributions rather than relying on dividends alone.

Practical worked example (illustrative)

The numbers below are illustrative to show mechanics, not tax advice. Always check current thresholds.

This shows employer pension contributions reduce the tax base for the company and can be more tax-efficient than taking the same money as salary or dividends — but the company needs cashflow to pay those pensions, and dividends are still needed for personal liquidity.

Compliance and admin you must not skip

• Run payroll through PAYE and submit RTI to HMRC on time. If you pay yourself a salary, you must operate PAYE.
• Keep accurate minutes and dividend resolutions when paying dividends, and ensure distributable reserves exist before declaring dividends.
• Document any salary sacrifice agreements in writing and update payroll records.
• Meet auto-enrolment duties — assess staff (including directors if applicable) and keep records of eligibility and communications.
• File company accounts and corporation tax returns on time so tax planning remains compliant.

How I usually advise clients

When I work with a client moving from sole trader to limited company I typically:

• Review goals: Do they want to minimise current tax, maximise pension savings, or protect state pension credits?
• Pick a sensible base salary — frequently to use the personal allowance or to sit around the NI threshold depending on pension/state benefit priorities.
• Recommend employer pension contributions where the client wants to prioritise retirement savings — because they’re corporation tax-deductible and avoid NI.
• Use dividends to extract additional profit, ensuring clear records and enough distributable reserves.
• Set up payroll (Xero Payroll, FreeAgent, IRIS or another system) and ensure RTI and pension software are connected so everything runs smoothly.

If you want specific figures for your situation, tell me the company profit you expect, whether you need to protect NI years for state pension, and how much you’d like to put into pension each year. I can then sketch an example split and the likely tax and NI effects using current HMRC thresholds.