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Paying Tax as a Sole Trader (Guide for 2020/2021)

Learn the basics of paying tax as a sole trader with this handy guide.

Your First Business

If you are looking to start a business, at some point you will need to pay tax. Depending on which type of business you decide to start, there will be different laws regarding the tax you need to pay. If, like me, you want to start a small business or become a freelancer, then you might want to become a sole trader. Paying tax as a sole trader is different to paying tax as an employee or as the owner of a limited company.

In this article, I will go through how to pay tax as a sole trader, and the kinds of things you need to be aware of. From deadlines and allowances, to National Insurance and filling out a tax return. Let’s get into it!

Contents

Paying Tax for the First Time

If you have had a job before, you will probably have noticed the PAYE section on your payslip. This stands for Pay As You Earn, and it is a structure that allows the tax that you owe to be paid at source, that is before any money comes into your bank account. This means you never need to worry about filling out tax returns. So, becoming self-employed for the first time will also provide you with your first taste of the Self Assessment scheme.

It’s not as scary as it might sound, especially if you’re not expecting to earn a huge amount of money in your first year. Even if you are, the processes below will stay the same. I will touch on the different tax brackets and limits, but the focus will be to make this article the ideal reference point for those paying tax as a sole trader for the first time.

 

How to Pay Tax as a Sole Trader

You need to register as self-employed if you earned more than £1000 in profits in the last tax year from self-employment. Let’s say you are a freelance writer and you made £15,000 (in profits) from the 6th of April 2020 to the 5th of April 2021. You would legally need to register as self-employed (by the 5th of October 2021), and so you choose to become a sole trader.

Self Assessment

You would then need to fill out a Self Assessment tax form, which is also referred to as a tax return. You can do this online, or by filling out a paper form. After you put in all of your income and expenses (if you have any), the Self Assessment form will calculate the tax that you owe.

If you are filling out the paper form instead, you will need to do the maths yourself! Don’t worry, it’s not too hard. However, if you don’t feel comfortable with this kind of thing you can hire an accountant. This usually isn’t cheap and is only really needed if you have a lot of complex accounting to do.

But before we get into the how of paying taxes, let’s discuss the when.

 

Self Employed Tax Deadlines

Unlike when you are employed by a company or other business, the tax you need to pay is paid directly by you. This means you need to pay it by a certain date, or you might be penalised. There are a few key dates to know, but they stay the same each year. The first date to think about is the start of the tax year.

The UK Tax Year

The UK tax year runs from the 6th of April to the 5th of April in the following year. This means that when you are calculating the tax that you owe, you only consider any earnings and expenses from within this window. There are a few different methods you can use, but the one that is most useful for small business is cash basis accounting.

This essentially means you only need to count the money you actually earn or spend within the tax year, and don’t need to add in money you are owed or that you owe to others. For example, if you receive or send an invoice on the 3rd of April, but don’t pay or receive payment for it before the 5th of April, you don’t include that in your tax return. It applies to both income and expenses.

This article is all about keeping it simple. If you want to learn more about the different methods of accounting, and about tax in general, the best source of information is the Gov.uk website.

Online Self Assessment

The next dates to think about are the deadlines for reporting your taxes via Self Assessment. If you are filling out your Self Assessment online, you have until midnight on the 31st of January of the year after the end of that tax year to submit it. This means you have until midnight on the 31st of January 2021 to submit your tax return for taxes owed for the 2019-2020 tax year.

Paper Form

If you do decide to fill out the paper form instead, you will need to submit it much earlier. Paper tax returns are due by midnight on the 31st of October of the same year. This means you would need to submit your return by midnight on the 31st of October 2020 for the tax year ending on the 5th of April 2020.

Paying Tax

You must pay the tax that you owe by midnight on the 31st of January of the following year. This means that if you are submitting your tax return online, you have the same deadline for submission and payment. Of course, it is always recommended to both fill out your tax return and pay any tax that you owe as soon as possible. It is just smart to do things early when it comes to tax, and it saves you frantically rushing around to sort things out at the start of the new year.

Payments on Account

However, there is a second payment date you need to consider, which is midnight on the 31st of July of the same year in which your tax year of interest ended. This is part of a system called ‘payments on account’. This is a somewhat complex system introduced by HMRC to allow self-employed people to pay their tax over two payments.

I say it is complex because there are a few caveats to it, and most guides online seem to struggle to make it clear as to who actually needs to pay it. For this reason, I will dedicate a separate article to payments on account and upload that soon. You can find out what the Gov.UK website says about payments on account here.

However, the short answer for this article is that you will need to pay the remainder of any tax you owe for the tax year of interest by midnight on the 31st of January, along with 50% of the estimated tax you will owe for the next tax year. Then, you pay the other half of this estimate by midnight on the 31st of July. I did say it was confusing!

Beyond the Scope of This Article

It has its benefits and its disadvantages. I will go through each of these in detail in my article on payment on account, along with several examples so you can get the hang of it. I strongly recommend you familiarise yourself with it, as many people get caught off guard in their first year as a sole trader when their tax bill is about 1.5x what they expect it to be.

But enough about deadlines! We now need to consider tax free allowances.

paying tax as a sole trader
Signing in to fill out your Self Assessment online

 

Sole Trader Tax Free Allowance

Everyone in the UK is subject to something called the tax-free Personal Allowance. This is a sum of money which you can earn without having to pay any tax on it. At the moment, it is £12,500, but it is often revised and increased to correspond with things like the rising cost of living. For example, back in 2010 it was just £6475!

It should also be noted that the specific tax-free allowance you are eligible for will depend on your tax code. The most common tax code is 1250L, which most people working for a company will have. In this case, the Personal Allowance is actually £12,509. Your tax code will be altered by various benefits you claim too, which will in turn affect how large your Personal Allowance is.

No Tax Code

If you are only self-employed, you will not have a tax code and will have an allowance of £12,500. If you are both self-employed and traditionally employed, you will have a tax code for the income you earn from employment. For the remainder of this article, we will be assuming you do not have a tax code, and thus have a tax-free Personal Allowance of £12,500.

Large Incomes

When you earn more than £100,000, the allowance drops by £1 for every £2 you earn over this amount. For example, if you earn £110,000 you are earning £10,000 more than this threshold. Thus, you need to divide this amount by 2, and that will give you the amount you need to deduct from your Personal Allowance. In this case it would be £10,000/2, which is £5,000.

This means if you were to earn £125,000 you would end up being ineligible for any of your Personal Allowance. This is because you would be £25,000 over the threshold which, when divided by 2, equates to £12,500. It seems as if the idea is that if you are lucky enough to make this amount of money, you can probably afford to be subject to that little bit more tax. Whether or not those earning more than £125,000 feel this way is another matter!

Personal Allowance Example

But how does the Personal Allowance work? Well, let’s take our example of the freelance writer earning £15,000. They are earning more than £1000 in profits, so we can check the box that they need to register as self-employed. They are also earning more than £12,500, so they also need to pay some tax. But how much tax do they need to pay?

We will go into the specific tax brackets and their rates in a moment, but a simple calculation here shows us how much money the person needs to pay tax on for a start. If you earn more than your tax-free Personal Allowance, you only need to pay tax on money you earn above that allowance. This is a key thing to note, and it is often where people get stuck.

In this case, our writer would only need to pay tax on £2500 of their earnings. This is because they take their allowance away from their total profits, £15,000 – £12,500, and they are left with £2,500. This idea of only paying tax on earnings above a certain limit comes into play when we consider the specific tax rates, and also when we consider National Insurance contributions.

Trading and Property Allowances

Along with the tax-free Personal Allowance, sole traders can also claim a trading or property allowance. These are both valued at £1000, and they both work in the same way. Essentially, it is an allowance that is similar to the Personal Allowance, and it can be used on top of it.

However, it cannot be used alongside the claiming of expenses. I plan to go into the basics of profits and expenses in another article, but expenses are basically any money that you spend on the business. You can find out more about what qualifies as a business expense here. Getting to grips with the idea of profits and expenses is vital for paying tax as a sole trader.

Trading Allowance

You don’t pay tax on your expenses, so it is definitely advantageous to claim expenses where you pay them. However, if your business does not have any expenses, or has less than £1000 worth of them, claiming a trading allowance may be an option for you. If you do pay more than £1000 worth of expenses, you will be paying more tax than you need to if you decide to claim the trading allowance instead!

Property Allowance

The property allowance works in exactly the same way, but you can only claim it if you earn money directly from land or property. You can claim both, but once again you will not be able to claim any expenses if you claim either of them. It can be worth it for those with no or few expenses, but note that you can only claim up to the amount of income you earn above your Personal Allowance.

By this I mean that if you earn £13,000, i.e. £500 more than your Personal Allowance of £12,500, you can only claim a trading or property allowance of up to £500. If you had expenses worth just £400, you would indeed be saving some money by claiming the trading/property allowance (£20 to be exact!).

So, now that you know your allowances, let’s talk about tax rates.

 

Tax Rates for Sole Traders

Tax rates can be confusing, but once you know how they work it just becomes a case of doing a few simple calculations. Below are two tables, with the first being the tax rates in England, Wales and Northern Ireland. The second table is for those living in Scotland, like myself, where things are a little different. However, the process for working out how much tax you owe is the same across the UK.

Tax Rates in England, Wales and Northern Ireland

Profits Above Personal Allowance Tax Rate
Up to £37,500 20%
£37,501 – £150,000 40%
Over £150,000 45%

Tax Rates in Scotland

Profits Above Personal Allowance Tax Rate
Up to £2085 19%
£2086 – £12,658 20%
£12,659 – £30,930 21%
£30,931 – £150,000 41%
Over £150,000 46%

Note that the range on the left-hand side corresponds to profits earned above the tax-free Personal Allowance and does not correspond to total earnings or profits. This will become clearer in the examples below.

 

Example of Paying Tax as a Sole Trader

Before we go through some examples of paying tax as a sole trader, let’s clear up a few terms. I will use the words ‘earnings’ and ‘earned’ to refer strictly to your business’ profits. Your profits are what is left over when you take away your expenses from your total income, or revenue. You will only pay tax on your profits, and not your total revenue, unless you don’t have any expenses and don’t take any extra allowances.

You do not pay tax on your revenue, only on your profits.

The examples below also only take into account income tax, and not National Insurance contributions. For examples with both, head to the end of the article.

For the examples below, I am going to illustrate them using the figures for the rest of the UK to keep things generalised. However, I will also go through one example at the end using the figures for Scotland, but note that the same processes apply for both, just with different numbers.

Example 1. Profits = £15,000

Profits Taxable Amount Tax Rate Tax Due
£0 – £12,500 £0 0% £0
£12,501 – £15,000 £2500 20% £500
Total Tax Due £500

Example 2. Profits = £75,000

Profits Taxable Amount Tax Rate Tax Due
£0 – £12,500 £0 0% £0
£12,501 – £50,000 £37,500 20% £7500
£50,001 – £75,000 £25,000 40% £10,000
Total Tax Due £17,500

Example 3. Profits = £200,000 (No Personal Allowance as profits are greater than £125,000)

Profits Taxable Amount Tax Rate Tax Due
£0 – £37,500 £37,500 20% £7500
£37,501 – £150,000 £112,500 40% £45,000
£150,001 – £200,000 £50,000 45% £22,500
Total Tax Due £75,000

Example 4. Profits = £200,000 in Scotland (No Personal Allowance as profits are greater than £125,000)

Profits Taxable Amount Tax Rate Tax Due
£0 – £2085 £2085 19% £396.15
£2086 – £12,658 £10,573 20% £2114.60
£12,659 – £30,930 £18,272 21% £3837.12
£30,931 – £150,000 £119,070 41% £48,818.70
£150,001 – £200,000 £50,000 46% £23,000
Total Tax Due £78,166.57

It is clear there are some differences between the two tax systems. This is why it is important to understand the different tax brackets and what they could mean for you. If you want to see a comprehensive – albeit slightly overwhelming – table of all of these rates without the tax-free allowance included, check out this page on the Gov.uk website.

 

Paying National Insurance as a Sole Trader

Now that we have looked paying income tax as a sole trader, the final piece of the puzzle of paying tax as a sole trader is National Insurance. National insurance is a tax that contributes towards your eligibility to receive various benefits, such as the state pension when you retire.

If you have worked for an employer previously you may have seen this on your pay slip next to your PAYE tax payments. There are various classes of NI, with the two important ones for sole traders being Class 2 and Class 4. You can pay National Insurance voluntarily, and you can find more details about this here.

National Insurance Rates for Self Employed

You will pay Class 2 National Insurance Contributions (NIC) if you earn at least £6,475 per year as a sole trader. These contributions are a flat rate of £3.05 per week, or £158.60 per year. If your profits were only £5,000, you would be exempt from paying this under the Small Profit Threshold (SPT), which is set at £6,475 for 2020/2021.

You should note that this threshold corresponds only to profits earned from self-employment. This means if you are working for another employer and earning money from them and paying tax through PAYE alongside self-employment, you will only need to add up your income from the self-employment.

Class 2 NIC

For example, let’s say you earned £7,000 from your employer and then £5,000 from freelancing. You would not need to pay any Class 2 NIC, as your earnings from self-employment are below the Small Profit Threshold. You also wouldn’t need to pay any of the second class of NIC, Class 4.

Class 4 NIC

Class 4 NIC uses a scaled system, similar to that used for income tax payments. In this case, if you bring in profits of more than £9,500, you pay Class 4 NICs at a rate of 9%. If you earn anything below that threshold you don’t pay any. Once you start earning more than £50,000, this decreases to 2%. However, this once again works using a scaled system, so you would pay nothing on the first £9,500, 9% on the first £41,500 of profits (£50,000 – £9,500), and then 2% on any profits above £50,000.

Note that unlike income tax, this allowance of £9500 applies to everyone, and there is no threshold above which your allowance decreases.

National Insurance Example

As a sole trader, you pay National Insurance through your tax return. Just as with paying income tax as a sole trader, the online form does all of the work for you. Once again, you will need to do some simple maths if you are looking to fill out the paper form. I have given a few examples below of paying National Insurance as a sole trader to help you. Contrary to those for income tax, the same rates are used across the UK for National Insurance.

After I give these examples, I will give a few that include both income tax and National Insurance for different tax brackets. Note that these examples are all for Class 4 National Insurance contributions only. For your total NIC simply add on £158.60 to the total in the table, excluding of course the first example where the profits are below the SPT.

Example 1. Profits = £3000 (Less than the Small Profit Threshold for Class 2 NIC and less than the £9500 threshold for Class 4 NIC)

Profits Amount Subject To NIC NIC Rate NIC Due
£0 – £3000 £0 0% £0
Total Class 4 NIC Due £0

Example 2. Profits = £40,000

Profits Amount Subject To NIC NIC Rate NIC Due
£0 – £9500 £0 0% £0
£9501 – £40,000 £30,500 9% £2745
Total Class 4 NIC Due £2745

Example 3. Profits = £80,000

Profits Amount Subject To NIC NIC Rate NIC Due
£0 – £9500 £0 0% £0
£9501 – £50,000 £40,500 9% £3645
£50,001 – £80,000 £30,000 2% £600
Total Class 4 NIC Due £4245

 

Income Tax and National Insurance

Finally, I will give some examples of paying both income tax and National Insurance as a sole trader. This will give you a feel for the kind of income you can expect in your pocket after all of your deductions are made. I have already gone through examples of no tax and NIC being paid, so the focus here will be for the specific tax brackets that do require some tax to be paid. Again, I will give examples for the rest of the UK, with one at the end for Scotland too.

Example 1. Profits = £15,000

Profits Taxable Amount Tax Rate Tax Due
£0 – £12,500 £0 0% £0
£12,501 – £15,000 £2500 20% £500
Total Tax Due £500
Profits Amount Subject to Class 4 NIC NIC Rate NIC Due
£0 – £9500 £0 0% £0
£9501 – £15,000 £5,500 9% £495
Total Class 4 NIC Due £495
Total Class 2 NIC Due £158.60
Total Due To HMRC £1153.60
Take Home Pay £13,846.40

Example 2. Profits = £40,000

Profits Taxable Amount Tax Rate Tax Due
£0 – £12,500 £0 0% £0
£12,501 – £40,000 £27,500 20% £5500
Total Tax Due £5500
Profits Amount Subject to Class 4 NIC NIC Rate NIC Due
£0 – £9500 £0 0% £0
£9501 – £40,000 £30,500 9% £2745
Total Class 4 NIC Due £2745
Total Class 2 NIC Due £158.60
Total Due To HMRC £8403.60
Take Home Pay £31,596.40

Example 3. Profits = £200,000 (No Personal Allowance)

Profits Taxable Amount Tax Rate Tax Due
£0 – £37,500 £37,500 20% £7500
£37,501 – £150,000 £112,500 40% £45,000
£150,001 – £200,000 £50,000 45% £22,500
Total Tax Due £75,000
Profits Amount Subject to Class 4 NIC NIC Rate NIC Due
£0 – £9500 £0 0% £0
£9501 – £50,000 £40,500 9% £3645
£50,001 – £200,000 £150,000 2% £3000
Total Class 4 NIC Due £6645
Total Class 2 NIC Due £158.60
Total Due To HMRC £81,803.60
Take Home Pay £118,196.40

Example 4. Profits = £200,000 (in Scotland, no Personal Allowance)

Profits Taxable Amount Tax Rate Tax Due
£0 – £2085 £2085 19% £396.15
£2086 – £12,658 £10,573 20% £2114.60
£12,659 – £30,930 £18,272 21% £3837.12
£30,931 – £150,000 £119,070 41% £48,818.70
£150,001 – £200,000 £50,000 46% £23,000
Total Tax Due £78,166.57
Profits Amount Subject to Class 4 NIC NIC Rate NIC Due
£0 – £9500 £0 0% £0
£9501 – £50,000 £40,500 9% £3645
£50,001 – £200,000 £150,000 2% £3000
Total Class 4 NIC Due £6645
Total Class 2 NIC Due £158.60
Total Due To HMRC £84,970.17
Take Home Pay £115,029.83

 

Hopefully the examples above give you an idea of what to expect when it comes to paying tax as a sole trader. It can be a complex topic, but my goal is to simplify these difficult ideas and concepts and make them as easy to understand as possible.

If you want to learn more about starting your own business, check out the rest of the articles here on the blog. If you want to be notified when the next post goes live, and gain access to some exclusive content, be sure to join my email list below!

 

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Chris Hanna

Chris Hanna

I'm Chris, the creator of Sophical Content.

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