Self Employed Tax Explained

I know that self-employment 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.  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.

If you haven’t registered as self-employed yet, then follow this guide.

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.

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.

How Do The Self Employed Pay Tax?

Here’s a quick summary of how taxes work, 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 by a client, the money you receive has no tax deducted from it. Meaning it is your responsibility for working out how much tax you need to pay from your earnings.

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).

Basic Tax Terms I Recommend You Get to Grips With

Tax Year

The tax year in the UK runs from 6 April to 5 April every year.

Business Profit

HMRC defines profit as “All your business income minus your allowable business expenses”. That means everything you get paid from your clients/customers minus the business expenses HMRC permit you to deduct.

Business Income

Everything you get paid from all your different sources of income like your clients, customers or affiliate schemes in your business.

Allowable Business Expenses

Generally, most of the things you pay for as part of running your business are allowable – that means they you can include them when it comes to working out your taxes. But there are certain expenses you can’t claim even though you may have paid for them as part of running your business. That’s things like:

  • Fines and penalties
  • Personal expenses
  • Certain training courses
  • Entertainment
  • The money you pay yourself

I’ve written a guide dedicated to allowable business expenses including advice on what records you need to keep and what happens when you use something for work and personal reasons.

Personal Allowance

Everyone in the UK is entitled to earn a set amount tax-free every tax year. The amount changes at the start of every tax year, so you should keep an eye on changes especially if you regularly budget for your tax bill. The personal allowance for 2020/2021 is £12,500 and was the same for 2019/2020.

Personal Allowance Restriction

Your personal allowance starts to disappear once you earn more than £100,000. Once you earn over £100,000 your personal allowance begins to get taken back at a rate of £1 for £2 you earn, until your income reaches £122,000 and it is clawed back completely. That means anyone earning over £122,000 does not receive any personal allowance.

Paying 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 profit you make (all your business income less your business expenses). That’s why self employment is so attractive because you get to deduct costs before paying tax, unlike when you work for someone and you have access to very limited deductions.

You’ll pay income tax at the same rate as everyone else, so for the 2020/2021 tax year* you can earn up £12,500 tax-free. After this, you’ll pay income tax at 20% on your earnings up to £50,000 and 40% over that amount, until you reach £150,000 and have to pay 45%.

*the tax year runs from 6 April to 5 April each year

 2020/20212019/2020
Personal allowance 0%£12,500£12,500
Basic rate 20%£12,501 to £50,000£12,501 to £50,000
Higher rate 40%£50,001 and £150,000£50,001 and £150,000
Additional rate 45%over £150,000over £150,000

Example 1

You are self-employed and during the tax year 2020/2021 you make a profit of £40,000.

You’ll need to pay tax of £5,500 which is calculated as:

  • 0% on the first £12,500 profit
  • 20% on the remaining £27,500 profit

Example 2

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

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

That means your combined income from both is £52,000.

Your income tax bill for 2020/2021 would be £8,300 which is calculated as:

  • 0% on the first £12,500 income;
  • 20% on the next £37,500 income;
  • 40% on the last £2,000 income.

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

You’ll pay Class 2 national insurance of £3.05 per week when your profits go over £6,475 per year and Class 4 9% on profits between £9,501 and £50,000 and 2% on profits over £50,000

 2020/2021
Class 2 National Insurance£3.05 per week on profits over £6,475 per year
Class 4 National Insurance9% on profits between £9,501 and £50,000
2% on profits over £50,000

Paying 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:

  • Unemployment benefits
  • Statutory sick pay
  • Maternity pay
  • State pension
  • NHS

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.

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:

 2020/20212019/2020
Small profits threshold – no NICs below this threshold£6,475£6,365
Class 2 National Insurance£3.05 per week£3.00 per week

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 £6,475 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.

Class 2 National Insurance protects your ability to claim certain state benefits like maternity allowance and the state pension.

Failing to pay Class 2 national insurance means you may not be able to claim for state benefits or find yourself entitled to a reduced amount.

For this reason, many self-employed people choose to pay Class 2 National Insurance voluntarily.

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).

The current Class 4 National Insurance rates are:

 2020/20212019/2020
Small profits threshold – no NICs below this threshold£9,501£8,632
Class 4 National Insurance 9%£50,000£50,000
Class 4 National Insurance 2%over £50,000over £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 £9,501. You’ll pay Class 4 national insurance of £2,744.91 which is worked out as (£40,000 – £9,501) x 9%.

What Expenses Can You Claim Back on Your Taxes?

Your business expenses reduce the amount of tax you have to pay. Most of the things you pay for can be deducted but there are certain ones which HMRC do not let you deduct, even if you paid for them as part of your business. These are known as allowable and disallowable expenses

Expenses you cannot claim for against your taxes include:

  • Fines
  • HMRC penalties
  • General clothing
  • Normal everyday lunches

I’ve written a detailed guide to allowable and disallowable expenses which you should read, and I’ve included a downloadable cheat sheet that you can keep for tax-time.

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.

My bookkeeping spreadsheet comes with an in-built tax calculator that automatically estimates how much you owe, so you’ll know what you need to transfer.

How to Report Your Self-Employment Earnings

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. 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.

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.

Self Assessment Tax Return

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. Its 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 register as self-employed.

Once your income goes over £1,000, then you can earn up to £12,500 in profit for tax year 2020/2021 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.

You’ll also be able to make a profit of up to £6,475 and £9,500 during the tax year 2020/2021 before paying Class 2 and Class 4 national insurance, respectively.

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

Paying Voluntary Class 2 National Insurance

Do You Have to Pay Tax in the 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.

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.

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, they can declare you bankrupt and in the very worst of cases, you can go to prison.

Self Assessment Tax Return Penalties and Interest

What About VAT?

VAT is a tax charged 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

If your business’ taxable turnover exceeds £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.

An Overview of VAT

How To Avoid Paying Tax When Self Employed

The easiest way to avoid paying tax is to claim back all the 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:

  • Personal allowance
  • First-year allowances
  • Marriage allowance
  • Capital allowances.

Income Tax Allowances & Reliefs


New Here? Learn how to set up the financial side of your business with these easy to understand guides and resources:

  • Sole Trader or Limited Company? – Download my free calculator to check which business structure would help you to pay less tax;
  • Tax Records and Bookkeeping – Understand what tax records you’ll need to keep and how to set up your own bookkeeping system;
  • Self Employment Taxes Explained – Learn what taxes you’ll pay, how much and when;
  • VAT Guides – From registration to de-registration, VAT schemes and thresholds, these guides will take you through the basics every UK small business owner needs to know;
  • Invoice Template – Free template and step-by-step guide so you can get paid by your clients.
Anita Forrest
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.