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If you’re already a sole trader or just thinking of starting out as one, it’s important that you have a firm idea of the tax that you’re required to pay on your self-employed income. After all, as is the case for all 4.5m people working for themselves in the UK, it will be your responsibility to submit and pay accurate tax returns on time.
In this simple guide to sole trader tax, we’ll look at the types and amount of tax a sole trader is likely to pay, how much you should be setting aside, the best way to compliantly reduce your tax liabilities and much more.
When focusing on earnings from your business, it depends on the amount of profit you make in a financial year, which starts on 6th April and ends twelve months later on the 5th April. Profit is subject to tax once your income exceeds the tax-free personal allowance threshold, which for the 2020/21 tax year is £12,500 (rising to £12,570 for the 2021/22 tax year).
You’ll be glad to hear that tax is less complicated for sole traders compared to those who work through their own limited company.
We’ll now look at the types of sole trader tax and their rates:
Income Tax is paid on income you receive personally, whether that’s profit you’ve earned from your business, rental income from a property, money made from investments, by working as an employee or any dividends drawn from a company.
You’ll need to calculate all of this, minus any legitimate business expenses, before filing a tax return and paying HMRC by 31st January every year. In most cases, sole traders must also make a payment on account by 31st July the same year.
A payment on account is an advance payment towards the following year’s tax bill, and is equal to half the amount of tax you owe for the previous tax year. It’s HMRC’s way of helping you spread out your tax payments and collect money faster.
The only instances in which you won’t need to make a payment on account is if your last Self-Assessment tax bill was under £1,000 or if you’ve already paid over 80% of all the tax you owe.
Here are the Income Tax bands and rates for England and Wales for the 2020/21 tax year, ending on 5th April:
|Tax band||Taxable income||Tax rate|
|Personal allowance||Up to £12,500||0%|
|Basic rate||£12,501 to £50,000||20%|
|Higher rate||£50,001 to £150,000||40%|
|February 2021||Over £150,000||45%|
The Income Tax bands and rates for England and Wales for the 2021/22 tax year, which starts on 6th April, are:
|Tax band||Taxable income||Tax rate|
|Personal allowance||Up to £12,570||0%|
|Basic rate||£12,571 to £50,270||20%|
|Higher rate||£50,271 to £150,000||40%|
|February 2021||Over £150,000||45%|
If you live in Scotland, Income Tax is slightly different. You’ll find more information about Scottish Income Tax on the government website.
National Insurance Contributions (NICs) are payments made by self-employed workers and employees that help fund public services, like the NHS and various government departments. They also help people build up an entitlement to receive certain benefits, like the state pension.
If you’re a sole trader without any employees, there are two types of NICs to take into account. The following need to be paid as part of your Self-Assessment Tax Return or payment on account:
If your profit exceeds £6,475 (above the ‘Small Profits Threshold’), you’ll need to pay the equivalent of £3.05 a week (£158.60 per year) in Class 2 NICs. In the 2021/22 tax year (starting 6th April), the ‘Small Profits Threshold’ will increase to £6,515 per year.
If you record profit over £9,500 in the 2020/21 tax year you’ll need to pay 9% Class 4 NICs on any profit up to £50,000, and a further 2% on profit achieved over this. From 6th April, these thresholds increase from £9,500 to £9,568 and from £50,000 to £50,270 a year.
VAT is added to the cost of most things we all buy in the UK. As a sole trader, if your annual turnover exceeds £85,000 within a 12 month period or you expect it to within a 30 day period, you’re required to register for VAT and start charging it to your clients.
If and when this applies to your business, you’ll need to prepare, submit and pay quarterly VAT returns to HMRC. Don’t worry though, the idea is that the amount of VAT you charge clients (20% for most businesses) is paid to HMRC further down the line.
So in theory, VAT shouldn’t mean you lose out and in some cases there are gains to be made.
Sole trader tax is based on the profit made by your business. It therefore goes without saying that understanding what profit is and how it’s calculated is really important.
Profit is the money left over after all business expenses have been taken into account. Let’s say you turnover £40,000 in a tax year and your business expenses amount to £10,000 – your profit is £30,000, which is the amount you’ll pay tax on. Obviously it’s unlikely to be this straightforward in reality, but hopefully you get the gist.
Expenses are costs incurred when running your business. As highlighted in the above scenario, they offset the amount of tax you pay as a sole trader.
These expenses could be accounting fees, pension contributions, office rent or technology and software bought so you can carry out your work. While some expenses have what HMRC classes as a ‘dual purpose’, the majority can only be claimed if they are incurred ‘wholly and exclusively’ for your business.
To find out exactly which expenses you can and can’t claim as a sole trader, please click here.
Firstly, be very cautious of any complex schemes that claim to reduce your tax liability or promise that you’ll pay very little or next to no tax at all. The likelihood is that they’re non-compliant, meaning they should be avoided at all costs.
The safest way to legally minimise the amount of tax you pay is by claiming back every legitimate expense incurred when running your business.
When it comes to putting money aside for your sole trader tax bill, it’s usually best to overestimate. You don’t want to find yourself short when the Self-Assessment Tax Return deadline rolls round.
To work out how much to put aside for tax, you’ll need to keep a close eye on your profits. Saving 5% on top of your expected tax rate (whether 20%, 40% or 45%) is a sensible thing to do. For example, if your annual profit is likely to fall under £50,000, put aside 25% of this every month just to make sure you’re covered.
If you’re not sure how much profit you’ve made or need some expert advice, feel free to contact a friendly accountant at Nixon Williams.
Aside from VAT, which is submitted and paid quarterly, sole traders pay tax via the Self-Assessment Tax Return every January.
Most sole traders find that opening a separate account makes keeping track of income and expenses, and in turn, working out how much tax they owe, a lot easier.
With regards to paying yourself, as a sole trader you’re free to use the money you’ve earned as and when you like. After all, it’s yours and not the company’s. That said, keeping to a set amount each month will help with budgeting. You also need to make sure you have enough left over for tax, while building up a rainy day fund is generally seen as a smart thing to do.
You don’t need to navigate the world of sole trader tax on your own – there is plenty of help available. Whether you’d like support to make sure of your tax compliance, ensure your tax efficiency or simply to save you time and stress, don’t hesitate to get in touch with the team at Nixon Williams.