Navigating Self-Employed Tax Traps

Being self-employed offers the unique opportunity to ‘be your own boss’, but this comes with its own responsibilities and challenges.

Alongside the operational implications of working for yourself or running a business, navigating the world of taxes as a self-employed individual can be complex, and if you don’t manage your tax affairs correctly, this could result in costly penalties. Being on top of your tax planning and being aware of and navigating around potential pitfalls whilst making use of valuable allowances is therefore critical for any self-employed person.

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Income Tax and the 60% ‘trap’

A benefit of being self-employed is being able to claim allowable expenses against your taxable income, which can significantly reduce your tax bill. This can range from office costs such as rent, to business-related travel expenses, and professional fees such as accountancy fees.  

It is however important to be aware of tax traps that you may fall into, such as the 60% income tax ‘trap’. This is a band of earnings between £100,000 and £125,140 where you will effectively experience an income tax rate of 60%. This is because for every £2 you earn over £100,000 per annum, alongside being subject to income tax at 40%, you lose £1 worth of your £12,570 tax-free Personal Allowance. Within this banding of earnings, you will also be subject to national insurance contributions of 2%, given a combined rate of income tax and national insurance contributions of 62%. Known as the 62% tax trap.

One of the main levers you can pull to help reduce your tax liability and help you avoid this trap is increasing your pension contributions, as this reduces your ‘adjusted net income’. Pension contributions can effectively receive tax relief of 60% within this band of earnings. As an example, for a higher rate taxpayer earning £110,000, a £10,000 gross pension contribution will effectively only ‘cost’ £4,000, once all income tax relief (totalling £6,000) is received.

National insurance contributions and your State Pension entitlement

For the employed, as the case with income tax, national insurance contributions are typically taken directly from gross earnings, hence there is no need to calculate your national insurance liability due each tax year. For the self-employed, it is critical to make sure you calculate your correct national insurance liability, otherwise you may end up paying too little or too much national insurance contributions.

You must tell HMRC when you become self-employed, as most people pay any required class of national insurance contributions through a self-assessment tax return. There are two types of national insurance contributions you may have to make as a self-employed individual, which will depend on your profits for the tax year.

If your profits are £6,725 or more a year:

  • Class 2 national insurance contributions are treated as having been paid, hence do not have to be paid.
  • If your profits are more than £12,570, you must pay class 4 contributions. For the 2024/25 tax year, you’ll pay 6% on profits between £12,570 and £50,270, and 2% on profits over £50,270.

If your profits are less than £6,725 a year:

  • You do not have to pay anything, but you can pay voluntary class 2 contributions.
  • The class 2 rate for the 2024/25 is £3.45 a week.

One potential pitfall in planning is that if your profits are below £6,725 a year, and you do not make voluntary class 2 contributions, you may not receive a ‘qualifying year’ towards your national insurance record. In more challenging lower profits years, it therefore may be wise to pay voluntary contributions (totalling £179.40 a year currently) in order to access a potentially higher state pension entitlement along with other state benefits.

You may also have ‘gaps’ in your national insurance record for previous years, where profits were below the threshold for receiving a qualifying year’s credit. This could result in a reduced State Pension. However, you may be able to pay voluntary contributions to plug any gaps. It is therefore worthwhile checking your national insurance record, which can be done online on the government gateway, to see if you have any gaps, or how much it will cost to pay voluntary contributions and if you’ll benefit from paying voluntary contributions.  

Have you built up enough wealth in a private pension?

Employers are obliged to automatically enrol their employees into a workplace pension plan, but if you’re self-employed then it’s up to you to set up a private pension plan. Some self-employed people say their business is their pension and can be sold when they want to retire. However, this can be a high-risk strategy, and if your business goes under, not only have you lost your job, but also your potential pension fund.

It is therefore important to be diligent with pension saving if you are self-employed. One strategy may be to allocate a proportion of your income, or a fixed amount each month, to a private pension plan. This way any pension saving may be ‘automatic’ and builds good saving discipline.  

This approach can be combined with lump sum pension contributions. This type of planning is often undertaken towards the end of a tax year when there is a better understanding of earnings for the year, which may be more appropriate for those with more variable earnings year on year.    

Each year, as a self-employed individual, you will have an ‘annual allowance’ for pension contributions that are eligible for tax relief, as is the case for personal pensions in general. The annual allowance is currently set at £60,000 per tax year, although your tax relievable pension contributions will be restricted to 100% of your profits if your profits are lower than £60,000 in a tax year. 

If your earnings are over £260,000 as a self-employed person who is therefore not receiving employer pension contributions, your annual allowance may be ‘tapered’ down to as low as £10,000 per tax year.

It can also be possible to make use of any unused annual allowance from the previous three tax years, known as ‘carry forward

Registering for VAT

You must register for VAT with HMRC if your annual turnover in a year exceeds £90,000, or if you expect your annual turnover to go over £90,000 in the next 30 days. This threshold was recently increased from £85,000.

The registration timeline is within 30 days from the end of the month in which you exceed the threshold. For example, if total business sales in the previous 12 months exceed £90,000 on 14th March, you will have until 30th April to register.

Should I set up a limited company?

Setting up a limited company means your company’s finances are independent from your own. If you choose to be a sole trader, you only need to register with HMRC and complete a personal self-assessment tax return. If you are setting up a limited company, you’ll need to register the business with Companies House and with HMRC for tax purposes.

With a limited company, as the business is a distinct separate legal entity, the company’s finances are separate from the shareholders’ or directors’ personal finances, so you are only responsible for the amount of money you put into the business. As a sole trader, you are responsible for both personal and business debts, so personal assets such as your home could be at risk if something goes wrong.

Forming a limited company does come with incorporation costs, along with additional responsibilities such as filing annual accounts and management responsibilities. Being a sole trader comes with few formalities in comparison.  

A sole trader is typically a more straightforward approach and involves limited paperwork and obligations, but you might be at a disadvantage when it comes to benefiting from tax reliefs and being more tax efficient. The business structure that is the best option for you ultimately will depend on your personal circumstances, with both advantages and disadvantages to each approach. 

It's all about the planning

Whether you are a sole trader or run a limited company, it is crucial to work closely with professional advisers to ensure that you are mitigating tax as far as possible, as well as making use of valuable tax allowances. Alongside helping put in place a suitable financial planning approach, we can make suitable introductions to accountants and solicitors where appropriate.  

As a business owner you may be working tirelessly to create and grow a legacy to give you financial freedom. Our expert business financial advisers can help you accomplish these goals and work with you to protect the legacy you’ve worked hard to achieve.  

Please do therefore get in touch for a free initial consultation if you have any concerns surrounding tax planning as a business owner. We’re offering anyone with £100,000 or more in pensions, investments or savings a free cash flow review worth £500

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This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions. 

The Financial Conduct Authority (FCA) does not regulate cash flow planning, estate planning, tax or trust advice. 

The information contained within this article is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change.