Sole Trader Tax and Ways to Reduce It

Sole trader tax rates can be difficult to navigate for many because you will be taxed personal income tax rather than a corporation tax on your profits.

So what’s the deal with sole trader tax rates? Well, put simply, it’s the same as any other individual personal tax rate with the difference being how the tax is paid.

There’s a small difference in National Insurance, an employed individual pays class 1 whereas a sole trader pays class 2 & 4.

In this blog, we’ll look at how sole trader tax works, what allowances will be available to you and when you should consider forming a limited company.

We’ve packed this blog with some useful advice covering the top level of tax for sole traders and smaller businesses, but for the best results speak to an accountant.

How does sole trader tax work?

So as stated if you operate as a sole trader, you’ll pay the same tax as any other employee of a business with the standard UK tax bands, meaning you can earn the same before tax and pay the following rates:

• Personal Allowance: Up to £12,570 – 0%
• Basic Rate: £12,571 to £50,270 – 20%
• Higher Rate: £50,271 to £125,140 – 40%
• Additional Rate: Over £125,140 – 45%

However, a sole trader’s income cannot truly be known until you file your self-assessment tax form. Therefore, for a sole trader, you will pay tax in one lump sum at the end of the year, rather than monthly as an employee. You may also have payments on account to make which are due in January and July each year.

Another point to note is because you’re working for yourself, you’ll pay a different kind of national insurance.

You will have to pay class 4 and class 2 national insurance with the exact amount dependent on how much you earn. Here are the rates:

• Class 2 NICs: £3.45 per week if profits are over £12,570.
• Class 4 NICs:

– 10.25% on profits between £12,570 and £50,270.

– 3.25% on profits over £50,270.

You can also read the government guidance on rates and allowances to learn more.

So now you should know what tax you should be paying, how can we help you get that figure down?

Make use of your sole trader tax allowances

When you’re self-employed you may be entitled to some generous tax allowances of up to £1,000.

If your business’ turnover is below £1,000, you won’t need to tell HMRC about this allowance. However, you will have to register for self-assessment if you exceed the £1,000 figure.

This trading allowance is available to anyone self-employed, while HMRC in most cases won’t request to see recorded proof for you to claim your £1,000 tax-free allowance, it’s important to keep a record in case they ever do. Reasons HMRC might do this could be as part of a random check or if they may have potentially spotted some fraudulent activity.

When to set up a limited company

Now if you’re a sole trader and you’re doing very well for yourself, you’ve probably been looking at further ways to reduce your tax bill.

Put simply, there’s no magic formula to legally reduce tax but there are a few savvy ways you can save yourself a few thousand quid.

Setting up a limited company lets you break down how you withdraw cash from your business. With dividend tax rates being lower in the basic band, you’ll be able to mix this with a standard salary.

Limited companies can also be a great and cost-efficient way to grow your business, cheaper. How? As a sole trader every penny you make will be taxed in line with the UK tax bands, meaning if you’re making enough to get up into the additional tax band you could be looking at 45% tax on your profits (I bet you’re feeling light-headed just thinking about that).

Instead, with a limited company, it’ll be deemed a separate entity, therefore if you want to keep some cash to spend on growing the business you can keep it held within the business by only paying corporation tax which is a much healthier 19-25%.

Of course, this money will be taxed again when you withdraw it for personal use.

Wrapping up

Taxation for sole traders is quite a complicated subject, it’s about being savvy with your money so that you don’t pay unnecessary tax.

If you’re starting as a sole trader and haven’t hit the big leagues yet, it’s most likely you won’t have to do anything savvy except file your self-assessment at the end of the financial year.

But once you make it big, a mix of creating a limited company, withdrawing dividends and paying yourself a salary may be the right way to go.

Need help with your sole trader tax? Get in touch with our London accountants and we can tell you what to do.