Tax on self-employment income while remaining employed
“I have a full-time job, but I have started doing some freelance work in my spare time. What do I need to do about my taxes, how much tax will I have to pay, and when?”
Whether to register the new business with HMRC
First of all, whether starting self-employment as a sole trader or a partnership, you should probably register with the tax office as a new business. This is a legal requirement if there is tax or National Insurance to pay as a result of your side business, which is highly likely if your combined income from employment and self-employment is over the tax-free Personal Allowance of £7,475 and there are no other complicating factors (tax credits are not taxable). It makes no difference if you are already paying tax on your employment income through PAYE. Tax is always calculated on total income, and there are no allowances or registration exemptions specific to self-employment. For example, if your employment earnings are over £7,475, and your business income is only £500, in most cases there will be tax to pay on that income and so you must register.
It is currently HMRC policy that all new businesses should register with them, regardless of size and even if there will be no tax to pay. Note however that this is only their preference, and goes beyond their legal powers.
Registering is very straightforward, and can be done online on this page of the HMRC website. You only register as a self-employed person once, regardless of how many different businesses you have.
What happens after you are registered?
Once registered, you will be allocated a Unique Taxpayer Reference (UTR) number, unless you already have one.
Registering as self-employed in this way does not mean that the tax office will tell your employer about your sideline business, as your own tax affairs are confidential. It is also unlikely that your PAYE tax code will need to change, for the first year or 2 at least. See: Will my employer find out about my business?
Self-employed people usually have to pay Class 2 National Insurance contributions at a rate of £2.50 per week (in practice they are paid monthly). However, if expect your self-employed income to be less than £5,315 per year, you will can apply for an exemption. See more about Class 2 National Insurance.
As someone with self-employment income, you will be sent a self-assessment tax return in April every year, on which to report your total income (both employed and self-employed) for the tax year that has just finished. You will need to keep records of your business income and expenses so that the tax return can be completed. You can choose to prepare your business accounts to any date each year, rather than having to use the anniversary of when the business started. 31 March or 5 April are the simplest options for tax purposes, so most people opt for either of those.
How do I work out my taxable profits?
Unfortunately there is nowhere near enough space to cover every accounting adjustment and allowable expense here. Generally, expenses are allowed if they are incurred for business purposes. For expenses with joint business and private use, such as telephone and motoring expenses, you can usually claim the business proportion, which might be 10% or 25% if you also have a full-time job. You can also claim a small proportion of your household running expenses, to cover using your home for business purposes. The exact proportion will depend on whether you have a dedicated office, or just a desk in the corner of a multi-purpose room that you use once a week for admin.
The purchase of equipment, which is generally more expensive items that are going to stay in your business for more than a year (rather than for sale as stock), is not a business expense. Instead, tax relief is given in the form of capital allowances. For most items, this simply means claiming the same amount of tax relief, but under the heading of Annual Investment Allowances. With cars, the position is more complicated.
When working out your profits on which tax is payable, 2 common mistakes are:
1. Thinking that if all income is reinvested back into stock, there are no profits and so no tax to pay. In fact, buying stock is a payment, but not an expense. It only becomes an expense when you no longer have it, usually because you have sold it. You pay tax based on profits, not payments.
2. Thinking that if all income is left in a business bank account, there are no wages/drawings, and so no tax to pay. In fact, with self-employment there is no distinction between business money and private money, so there is no question of paying yourself a “wage”. You pay tax on profits as they are earned, regardless of how you transfer your own money around.
How much will the tax be?
In working out the tax, you generally pay tax on your employment income through PAYE on your payslip each week or month, and tax on your business income based on the amount of profit (not turnover) that gets entered on your tax return each year.
Your tax-free Personal Allowance usually gets allocated to your employment, so the tax on your self-employment will be at your own highest tax rate. If your total income is below £42,475, the tax on your self-employed income will be 20%, but any income over £42,475 will be taxed at the higher rate of 40% (income above £150,000 may be taxed at 50%).
Additionally, you pay Class 4 National Insurance on your self-employed earnings at a rate of 9% on any income between £7,225 and £42,475 in a year, and at 2% on any income over £42,475. If your combined income goes over £40,000 in the tax year, the amount of Class 4 NI payable starts to be restricted (more details).
It is useful to know what percentage of self-employed earnings should be set aside for tax, but as seen, this is not possible. The amount could vary from 20% to 59% (possible, but rare). For someone with average earnings, we recommend setting aside around 25%, and then completing the tax return shortly after 5 April each year so that you get several months’ notice of what the final liability will be.
When will the tax have to be paid?
The total tax and Class 4 National Insurance on your self-employed income (together with any other minor tax adjustments that get sorted out on the annual tax return) is usually payable by 31 January after the end of the tax year. So, if you started your business in October 2011, this falls in the tax year to 5 April 2012, and the tax on the business income up to 5 April 2012 will be payable by 31 January 2013.
If the tax and NI payable from your tax return is over £1,000 per year, and this total is more than 20% of your total tax paid for the year, then you may have to start making advance payments on account of tax every 6 months.
Alternatively, provided your tax return is submitted online by 30 December, and your combined liability for 31 January is less than £3,000, you can pay the tax by having it deducted from your salary via PAYE throughout the following tax year. This will result in your tax code changing, which will signal to your employer that you probably have another source of income. If you do not want the tax to be collected this way, tick box 2 on page 5 of the tax return before filing it.
Once the tax return is submitted, you will receive statements in the post confirming the amount of tax payable and explaining how it can be paid.
Simple example for first year of business
Annual salary = £20,000. Assume a standard tax code of 747L, with no complications.
The business starts in September 2011. Profit from self-employment in year to 5 April 2012 = £10,000.
Tax on self-employed income at 20% = £2,000.
Class 4 National Insurance on self-employed income at 9% on earnings over £7,225 = £249.75.
Combined amount payable by 31 January 2013 = £2,249.75.
In addition, as this is more than £1,000, and it is more than 20% of the total tax paid for the year, extra payments (on account) of £1,124.87 (50% of the January payment) will also be required in January 2013 and July 2013. These payments can be deducted from any tax due in January 2014.
Alternatively, the £2,249.75 liability can be paid through PAYE evenly throughout the 2013/14 tax year.