Self-Employed Tax: How Does it Work?

I know that self-employed taxes can be a complicated subject, but they are an unavoidable part of working for yourself.  What tax do you pay? When and how do you report your earnings? And how do you (legally) reduce how much you pay to HMRC? If you aren’t sure where to start when it comes to taxes and you’re worried the tax-man is lurking around the corner, then this guide is for you. 

I’ll answer some of the common questions that I see online and was most asked in my previous life as a Chartered Accountant by people who have set up a business.  It’ll take away the worry that you’re missing out on tax allowances and show you the deadlines you need to know. But I know it can be complicated if taxes are new to you so don’t worry if you don’t understand it all at once – bookmark this page and come back to it when you come across each term in context so you can refer back and understand it better.

I only cover self-employment taxes, allowances and reliefs in this guide. If you have a Limited Company you’ll be affected by different taxes such as corporation tax and dividend tax.

Updated 14 January 2022

Friendly Disclaimer: Whilst I am an accountant, I’m not your accountant. The information in this article is legally correct but it is for guidance and information purposes only. Everyone’s situation is different and unique so you’ll need to use your own best judgement when applying the advice that I give to your situation. If you are unsure or have a question be sure to contact a qualified professional because mistakes can result in penalties.

1. How Do The Self-Employed Pay Tax?

Here’s a quick summary of how taxes and national insurance work for the self-employed, I’ll go into more detail about each part in this guide.

The self-employed are responsible for managing their own taxes. Unlike when you work for someone and they give you a payslip with all your taxes deducted, every time you get paid in your business or by a client, the money you receive has no tax deducted from it. Meaning it is your responsibility for working out how much tax and national insurance you need to pay from your earnings.

When you’re registered as self-employed with HMRC you’ll have a tax bill to pay twice a year (by 31 January and 31 July) as well as being required to fill out a tax return once a year to declare your earnings (by 31 January).

** HMRC has announced an extension to the filing deadline for 2022 as COVID continues to cause disruption. Taxpayers now have until 28 February to file their tax return without facing penalties, although interest on any unpaid tax will apply from 1 February 2022 as normal.

2. How Much Can You Earn as Self-Employed Before Paying Tax

You can actually earn £1,000 tax-free by utilising the trading income allowance during the tax year. It’s a little tax break that means if you get paid income (not profit) of £1,000 you don’t need to let HMRC know about it or registering with them as self-employed.

Once your income goes over £1,000, you can then earn up to £12,570 in profit for the tax year 2021/2022 without paying tax because of the personal allowance – the amount that everyone in the UK is entitled to earn tax-free. Even if you have no tax to pay, you must still register as self-employed and let HMRC know about your earnings. Once your profits go over the tax-free amount you’ll start to pay income tax as follows:

  • 20% (basic rate) on profits between £12,570 to £50,270
  • 40% (higher rate) on profits between £50,271 to £150,000
  • 45% (additional rate) over £150,000

If you have other forms of income for example because you are employed and self-employed then you’ll pay income tax based on all your combined earnings – read this guide to find out more.

Being self-employed, you’ll also pay national insurance on your business profits but again you won’t pay any if you earn up to the tax-free thresholds. Here are the national insurance rates for the 2021/2022 tax year:

  • Class 2 National Insurance £3.05 per week on profits over £6,515 per year
  • Class 4 National Insurance. 9% on profits between £9,658 and £50,270 and 2% on profits thereafter

Despite not having to pay Class 2 national insurance, some people choose to pay it voluntarily because it keeps their NI records up to date and protects their ability to claim state benefits like maternity allowance and the state pension.

The Autumn Budget was announced on 27 October 2021: read this guide to find out the upcoming changes to income tax and national insurance from April 2022.

3. Do You Have to Pay Tax in Your First Year of Self Employment?

The more you earn, the more tax you pay. There is no exemption because it is your first year working for yourself. That being said if you have an income (not profit) from your business of £1,000 or less you could take advantage of the trading income allowance, meaning your income is tax-free and doesn’t need to be reported to HMRC.

Depending on when you started self-employment, it can be up to 18 months before you have to pay any tax over to HMRC. But it is a good idea to put your tax money aside so you don’t spend it and then get hit with a large tax bill. Opening a separate business bank account will help – take a look at Starling which is free for one month.

You should also be mindful that in your first year of self-employment, your first tax bill will be 50% higher. That’s because, depending on your profits, you will probably need to pay a 50% contribution towards your next years’ tax bill – this is known as a payment on account.

self-employment tax and national insurance
Self-Employed Tax and National Insurance Explained

4. Income Tax When You’re Self-Employed

You’ll pay income tax and two types of national insurance (class 2 and class 4) based on the trading profit you make (all your business turnover less your business expenses).

That’s why self-employment is so attractive because you get to deduct business expenses before paying tax, unlike when you work for someone and you have access to very limited deductions.

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You’ll pay income tax at the same rate as everyone else, so for the 2021/2022 tax year you can earn up to £12,570 tax-free. After this, you’ll pay income tax at 20% on your earnings up to £50,270 and 40% over that amount, until you reach £150,000 and have to pay 45%.

 2021/20222020/2021
Personal allowance 0%£12,570£12,500
Basic rate 20%£12,570 to £50,270£12,501 to £50,000
Higher rate 40%£50,271 to £150,000£50,001 to £150,000
Additional rate 45%over £150,000over £150,000

Example 1

You are self-employed and during the tax year 2020/2021 after deducting allowable expenses, you make a profit of £40,000. You’ll need to pay income tax of £5,486 which is calculated as:

  • 0% on the first £12,570 profit
  • 20% on the remaining £27,430 profit

Example 2

You are employed and self-employed, so have two forms of income. During the tax year 2020/2021 you earned:

  • £40,000 from your employment
  • £12,000 profit through self-employment

That means your combined income is £52,000. Your income tax bill for 2020/2021 would be £8,232.20 which is calculated as:

  • 0% on the first £12,570 income;
  • 20% on the next £37,699 income;
  • 40% on the last £1,731 income.

In addition to income tax, you’ll need to pay two types of national insurance when you’re self-employed – Class 2 and Class 4. Again, the more you earn the more you’ll pay.

 2021/20222020/2021
Class 2 National Insurance£3.05 per week on profits over £6,515 per year£3.05 per week on profits over £6,475 per year
Class 4 National Insurance9% on profits between £9,658 and £50,270
2% on profits over £50,270
9% on profits between £9,501 and £50,000
2% on profits over £50,000

5. National Insurance When You’re Self-Employed

National Insurance is a type of tax where UK workers (whether employed or self-employed) pay into a ‘pot’ which then entitles them to claim certain state benefits such as:

When you are self-employed you need to pay two types of national insurance:

  • Class 2 National Insurance
  • Class 4 National Insurance

The amount of each of these you pay is based on your self-employment profits only (you don’t need to include any other income when working out how much you owe). If you are employed in a job, you’ll still need to pay Class 1 National insurance on your employment earnings, which your employer will calculate for you.

You’ll pay Class 2 national insurance of £3.05 per week when your profits go over £6,515 per year and Class 4 at 9% on profits between £9,658 and £50,270 and 2% on profits over £50,270.

5.1 Class 2 National Insurance

You’ll pay self-employed Class 2 national insurance when your business profits reach a certain level (known as the small profits threshold). Class 2 national insurance is paid at a fixed amount and the current rates are:

 2021/20222020/2021
Small profits threshold – no NICs below this threshold£6,515£6,475
Class 2 National Insurance£3.05 per week£3.05 per week

Example

You are self-employed and during the tax year 2021/2022 you make a profit of £40,000. Your profits exceed the small profits threshold of £6,515 so you’ll need to pay Class 2 national insurance of £158.60 (£3.05 x 52 weeks).

If you go self-employed part way through a tax year the amount you’ll pay will be pro-rated to match the number of weeks you were in business.

5.2 Class 4 National Insurance

You’ll pay self-employed Class 4 national insurance when your business profits again reach a certain level (known as the small profits threshold). Below this level, you’ll be exempt from paying class 4 national insurance. The current rates are:

 2021/20222020/2021
Small profits threshold – no NICs below this threshold£9,658£9,501
Class 4 National Insurance 9%£50,270£50,000
Class 4 National Insurance 2%over £50,270over £50,000

Example

You are self-employed and during the tax year 2020/2021 you make a profit of £40,000. You’re profits exceed the small profits threshold of £9,658. You’ll pay Class 4 national insurance of £2,730.78 which is worked out as (£40,000 – £9,658) x 9%.

6. When Do You Pay Self-Employed Taxes?

Self-employment taxes are due twice a year by the 31 January and 31 July. It’s really important to budget for your tax bill so you have the money ready. One of the easiest ways to do that is to tuck money away either monthly or every time you get paid at your highest rate of tax. That means it’s important you stay on top of your bookkeeping so you know how much tax you need to save.

Your payment on 31 July and part of the tax you’ll pay on 31 January is known as a payment on account. It is a contribution towards your next years tax bill, calculated each time as 50% of your current tax bill. That way by the time you reach the following January you’ll have already paid a portion of your bill, but you’ll make a new contribution.

You should also be mindful that in your first year of self-employment, your first tax bill in January will be 50% higher. You’ll be paying tax on money you haven’t even earned yet.

7. Reporting Your Self-Employment Earnings to HMRC

Once a year, you’ll need to report your earnings to HMRC using a tax return – this is what is known as ‘self assessment‘.

You’ll need to file your tax return by 31 January each year and most likely you’ll do this online. You can fill out a paper version but you’ll need to get it in sooner, in October instead of January. And if you do it online, HMRC works out your tax for you straight away. One tax return covers one tax year. So your return due by 31 January 2021 will cover your income and expenses for the tax year 2019/2020.

8. What Happens if You Don’t Pay Tax?

If you don’t pay self-employment taxes because your earnings are below the personal allowance or the trading income allowance, then there is nothing to worry about. As long as you register and declare your earnings to HMRC.

HMRC have ways and means of finding things out, so if you don’t pay self-employment taxes but know that you should have registered with HMRC as self-employed, then you can face penalties for failing to register, file tax returns and not paying taxes. Once HMRC does hit you with penalties and interest charges, they’ll offer you very little leeway when it comes to paying what you owe. In some cases, once they investigate, they can declare you bankrupt and in the most extreme cases, you can go to prison.

9. What About VAT?

VAT is a tax charged to consumers on most goods and services supplied in the UK. It stands for Value Added Tax and the current standard rate is 20%. There are three different types of VAT rates, which are applied depending on the goods or service being sold.

RateGoods & Services Rate Applies to:
Standard Rate 20%Most goods and services
Reduced Rate 5%Electricity, gas, carrycots, children’s car seats, maternity pads, sanitary protection products, nicotine patches
Zero Rate (0%)Books, newspapers, children’s clothing, certain food & drink, household water
VAT Rates

If your business’ taxable turnover exceeds the VAT threshold of £85,000 then you are legally required by HMRC to register for VAT. If that applies to you then once registered you must:

  • Charge VAT at the correct rate on everything you sell;
  • Deduct VAT you paid to your suppliers from the VAT you charged your customers;
  • Pay the difference on VAT paid and received to HMRC, normally quarterly;
  • Submit VAT returns using an HMRC approved bookkeeping software;
  • Keep VAT receipts.

Being registered for VAT carries more administration and reporting to HMRC. That being said, some businesses choose to voluntarily register for VAT because it brings tax and cash flow benefits.

10. How To Avoid Paying Tax When Self-Employed

The easiest way to avoid paying tax is to claim back all the allowable expenses you are legally entitled to. It is the most overlooked because people don’t stay on top of their bookkeeping, claiming expenses and keeping receipts. So make sure you set up a bookkeeping system, that you keep up to date because it is the easiest way to reduce your tax bill.

There are also other income tax reliefs and allowances that you may be entitled to that will help to reduce the amount of tax you have to pay including:

11. Key Takeaways

  • When you’re self-employed you’ll pay income tax as well as class 2 and class 4 national insurance but the amount you’ll pay depends on how much you earn above the tax-free thresholds;
  • You can deduct business expenses from your income which helps to reduce your tax bill, but not all expenses are allowable;
  • You’ll need to report your earnings on a tax return each year and if you do that online, HMRC will calculate your tax automatically.

Related:

Taxes are changing! From April 2024 sole traders will need to report their earnings and pay tax on a quarterly basis. This is known as Making Tax Digital, which you can read more about in this guide to help you get prepared.

About Anita Forrest

Anita Forrest is a Chartered Accountant, spreadsheet geek, money nerd and creator of www.goselfemployed.co - the UK small business finance blog for the self-employed community. Here she shares simple, straight-forward guides to make self-employment topics like taxes, bookkeeping and banking easy to understand.