Tax on Self Employed Income

The numbers in our example are based on HMRC’s rates and thresholds for the 2020/21 tax year. Income tax is commonly based on total earnings. So you’ll owe tax on earnings above the Personal Allowance. This applies to all your income, including employment and self-employment profits. We’ll cover income vs profits later.

If your sole trader profits are high, you may reach the highest tax bracket. You’ll pay more then. If you earn £35,000 from your employer and £20,000 from your sole trade, your total earnings year 2020/21 will be £55,000. After subtracting your £12,500 Personal Allowance, your taxable income is £42,000. Your income tax payment at a basic rate of 20% is £7,500. However, at a higher rate of 40%, you will have to pay £2,000 in income tax. Therefore, your total income tax payment will be £9,500. Note that these income tax rates do not apply to Scottish residents.

If your income exceeds your personal allowance, you must pay 20% income tax, provided it does not exceed the basic rate upper limit of £37,500 for the 2020/21 tax year. On the other hand, if your income exceeds the basic rate limit, you’ll have to pay income tax at a rate of 40% until you reach the higher rate limit, which is £100,000 for the 2020/21 tax year. So based on our example, you must pay 40% tax on earnings of £5,000.

When submitting your yearly Self-Assessment tax return, you must disclose the amount of tax that your employer has already deducted. In the preceding example, the employer-provided income of £35,000 has already been taxed under PAYE. HMRC is thus aware that a portion of your income is from employment.

Once you have filed your Self Assessment, HMRC will verify your self-employment income, which in this case is £20,000.

There are no changes to the National Insurance that your employer has deducted from your salary. When it comes to the profits that you have earned as a result of being self-employed, on the other hand, things are quite a bit different.

If your self-employment income is higher than £6,475 per year, you must pay a weekly flat rate of £3.05. Also known as Class 2 National Insurance. Primarily, PAYE is used by your employer to pay Class 1 National Insurance. Class 2 payments, on the other hand, are sent directly to HMRC through a direct debit arrangement.

It’s possible to pay Class 4 National Insurance if things are going well for you. For self-employed profits between £8,632 and £50,000, the tax rate is 9%, while it is 2% for profits beyond £50,000.

Class 4 National Insurance contributions are calculated similarly to income tax, with the amount based on your Self Assessment tax return. Using the identical numbers as in the preceding illustration, we will demonstrate how this works.

The self-employed person made £20,000. Class 2 National Insurance is £3.05 per week, times 52 weeks. This adds up to £158.60. Class 4 NI is 9% for self-employed profits between £9,500 and £50,000. As the profit is just £20,000, we will calculate 9% of £10,500, which is £945.00. The total National Insurance contribution would thus be £1,103.60.

Remember that you must also pay your Class 1 National Insurance through PAYE deductions from your employer. This is for your income from your employment.

A sole trader or a limited company are two options open to self-employed people who want to create their business structure in the UK. The only difference is if you opt to become a sole trader, then you are fully responsible for your business. For example, you are solely responsible for all of your business’s operations, including any financial commitments that arise as a result. 

If you opt to incorporate your own limited company, you will have a separate legal entity for which you may not be personally accountable for its debts. Nevertheless, you will have specific legal and statutory requirements to fill and undertake duties since you are the director of your limited company. There are also some tax repercussions.

One of the most significant benefits of registering as self-employed and being a sole trader is that you may deduct your business costs from your revenues. Your tax profits will exclusively be based on your self-employment income. However, there is a similar situation when it comes to limited companies. This is the case where the Corporation Tax is only applied to the company’s net income after all legally allowed expenses have been subtracted. 

Expenses such as pension payments, wages, and travel and lodging are all included here. However, determining what is and is not an admissible expense is a challenging process, as is making a claim for those costs. What’s most crucial to keep in mind is that all business expenses must be incurred exclusively for business purposes.

It’s not required to tell your employer, but you must tell HMRC. In fact, HMRC recommends that you let them know as soon as you start doing business from your new business. If your income as a self-employed sole trader exceeds £1,000 in a tax year, you must register your new business with HMRC. If you’re a full-time employee, this will happen after you get your first self-employment income.

You must register for Self Assessment if you earn more than £1,000 by October 5 after the tax year ends. You must notify HMRC if you wish to avoid the risk of a fine. If you don’t earn above £1,000, you don’t need to complete a Self Assessment. This is because HMRC has created the £1,000 trade allowance to remove the necessity for submitting a return in case this condition occurs.