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Tax and National Insurance When You Go Self-Employed

I’ve updated this post on 22 June 2020

In this guide, I’ll introduce you to the basics of self-employment taxes, national insurance, allowances and reliefs. I’ll also show you how to work out your tax the old fashioned way!

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

As a Chartered Accountant, self-employment taxes was the one topic I had a head start on as a business owner and I knew that handling my taxes was fundamental to me building a successful small business.

But I know it can be complicated if taxes are new to you. Don’t worry if you don’t understand it all at once.

Keep the guide handy, and when you come across each term in context, you can refer back to it so you 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.

Friendly Disclaimer: The information contained in this article is for guidance and information purposes only. It should not be relied upon as professional accounting, tax and legal advice. For specific advice relevant to your own situation, always contact a professional.

What Tax Do You Pay When You’re Self-Employed?

There are 3 types of taxes that you’ll need to pay:

  1. Income Tax
  2. Class 2 National Insurance
  3. Class 4 National Insurance

The amount of each of these you pay depends on how much profit your business makes during one complete tax year, after deducting any allowances you are entitled to.

Confused? Here are the basic 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.

Self-Employment Income

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 is 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.

So how much tax do you pay? Let’s look at each of the 3 different taxes in turn.

How Much Tax Do You Pay If You’re Self-Employed?

When you are self-employed you start paying income tax on your business profits over and above the personal allowance.

The more you earn, the more income tax you’ll pay.

If you have more than one form of income you’ll need to add this to your self-employment income before working out how much income tax you’ll owe.

Here are the current income tax rates:

 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.

What Happens if you don’t Pay Self-Employment Taxes?

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

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.

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

How Much National Insurance Do You Pay If 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 Happens if You don’t Pay National Insurance Contributions?

If you don’t pay national insurance contributions because your earnings are below the small profits threshold, then this is absolutely fine.

Not paying Class 2 national insurance however can have an impact on your ability to claim state benefits, so you may want to consider paying them voluntarily.

How Do You Pay Tax and National Insurance When You’re Self-Employed?

First things first, you’ll need to be registered as self-employed so HMRC knows to expect tax payments from you and can issue you with the details you need to make the payments.

Once you are registered with HMRC you’ll need to:

  • Fill out a tax return form once a year, by 31 January, to tell HMRC about all your income and expenses;
  • Pay all the tax and national insurance you owe by 31 January as well as a contribution to your next years tax bill, known as a payment on account.

What is a Self-Assessment Tax Return Form

A Beginners Guide to Payments on Account

What Allowances and Reliefs are there to Reduce Your Tax Bill?

The easiest way to reduce your tax bill is by claiming all the business expenses you possibly can.

That’s why getting a bookkeeping system in place that helps you record your expenses, estimates your taxes and generates the numbers you’ll for your tax return is so important

Other tax reliefs and allowances that you may be entitled to include:

If you want to find out more ways to reduce your tax bill, then read this post where I share my top 10 super simple ways you can save tax.

How Much Can You Earn Tax-Free When You’re Self Employed?

You can earn an income of £1,000 tax-free without needing to tell HMRC. Once you earn more than this, you’ll need to register with HMRC, but you won’t begin to pay tax until you earn more than the personal allowance.

Example 1

You are self-employed and your business makes £30,000 profit during 2019/2020. You have no other income so you can earn £12,500 tax-free and you’ll need to pay tax on £17,500 (£30,000 less £12,500).

Example 2

You are employed and self-employed during the tax year 2019/2020. You earn £30,000 from your employment and £10,000 being self-employed.

You are only entitled to the personal allowance of £12,500 once. This will probably be given to you through your employment, as this is where your highest salary is. Every month when your employer pays you, they will deduct one month’s worth of your personal allowance from your salary before they work out your tax.

Your income from self-employment will not be tax-free as you have used all your personal allowance up against your employment salary.

Even if you have no tax to pay, you’ll still need to fill out a tax return and declare your earnings to HMRC.

Is Your First Year of Self-Employment Tax-Free?

No, the first year of self-employment is not tax-free. However, often if someone is new to self-employment their earnings can be low or they have bought start-up materials that wipe out their business profits.

This means their personal allowance covers any income they have made or they have made a tax loss, so they have no tax to pay.

Even if you have no tax to pay, you’ll still need to fill out a tax return and declare your earnings to HMRC.

Wrapping Up

Taxes are an inevitable part of running a small business and the more money you earn the more you’ll have to pay – so you’ll never get away from them!

Taxes don’t need to be stressful, if you get prepared and understand exactly what you need to pay and when.

When you’re self-employed you’ll need to pay income tax as well as class 2 and class 4 national insurance.

It is your responsibility to work out how much tax you have to pay and fill out a self-assessment tax return once a year to let HMRC know how much your earnings are.

Don’t forget you may also need to make a payment on account on 31 July each year (a contribution towards your next years tax bill), so make sure you budget for that too!

If you are using my bookkeeping spreadsheet the automatic calculator will work out how much tax and national insurance you owe, including your payment on account.

This guide is number 2 in my 6 Core Elements of Self-Employment Taxes series.

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Anita Forrest
About Anita Forrest

Anita Forrest is a Chartered Accountant, spreadsheet geek, money nerd and creator of www.goselfemployed.co - a UK small business finance blog where she shares help and advice with the self-employed community to make topics like registering a business, bookkeeping and taxes easy to understand.