Self-employment comes with plenty of perks. But it isn’t short of challenges or obstacles either – namely around tax. Every penny is important when you set up on your own, so you’ll likely wonder how much is self-employment tax and how to reduce your tax bill.
Getting to grips with your finances is the key to paying less tax and keeping penalties at bay. To help you start identifying how you can give less money to the taxman, we’ve outlined some ways to cut down on tax for the self-employed.
Incorporate your business
Whether you’ve just started out as self-employed or have been established as a sole trader for a while, it’s often worth looking into the possibility of incorporating your business. This means you’ll be setting yourself up as a limited company, and you’ll be a director. It’s not just something viable for those increasing in size – even if it’s just you in the business, you’ll have the chance to reduce the tax you pay.
Directors can withdraw part of their earnings as dividends. They are free from tax altogether for the first £2,000. After this, you will need to give money to the taxman, but the rates are much lower than that of self-employment Income Tax. For basic rate taxpayers this is only at 7.5%, and for higher and additional rate payers you would pay 32.5% and 38.1% respectively.
This method has great tax-saving potential for the self-employed. Those who are only shareholders in a company may not necessarily have to fill in the Self Assessment tax return, unless they withdraw dividends over £10,000.
Offset all allowable expenses
When completing the Self Assessment form, you’ll be able to list all the expenses you make. HMRC offer tax relief on a variety of allowable work-related spends. Understanding which ones you can claim on is a great way to trim your tax bill.
Many starting out have limited knowledge on expenses, and so wonder: ‘What can you claim for being self-employed?’ The answer is that it varies depending on the nature of your business. Most will list travel, office equipment, and financial costs like insurance or bank charges. Bigger businesses will likely have more expenses such as the costs of staff, business premises and marketing, meaning they can claim on a wider range of expenditures.
There are specific rules around individual expenses. For example, with travel you can claim on fuel, parking and public transport fares, but not for the cost of journeys between your home and workplace.
Additionally, the expenses must be ‘wholly and exclusively’ for business purposes. If any costs were for a mix of personal and business usage, then you would offset only the amount proportioned to the latter. This may seem easy for some expenses, but others are a little more unclear – like costs incurred when working from home. For example, with heating you’d need to calculate the approximate amount of time you have spent working. There is the option to use simplified expenses for some costs, but not if you’re a limited company.
Claim on capital allowances
If you use the £1,000 tax-free allowance for trading, then you won’t be able to claim expenses, and the same applies to capital allowances. These can also only be offset if you are a sole trader or partnership, and if you use traditional accounting. Those who use cash accounting instead have just one capital allowance they can claim: a car that’s been purchased for business usage.
Self-employed people that apply traditional accounting have a much wider range of capital allowances to offset. Assets that you intend to keep for use in the business can be claimed, and common examples are equipment, machinery and vehicles. Capital allowances enable you to claim for the initial cost and the item’s depreciation.
It might also be possible for you to take advantage of the Annual Investment Allowance (AIA) for certain items. The AIA allows you to claim its full value. Cars, items you possessed prior to them being used in the business, and those given to you or the business, aren’t able to be claimed. There is a limit of £200,000 for AIA in each twelve-month period – if you exceed this, or the item can’t be claimed via AIA, you would instead use writing down allowances.
Contribute to a pension
Capital allowances may seem like an answer to the question ‘how to avoid paying tax if I’m self employed’, but they are ways to save on tax, and don’t fall under tax avoidance schemes. It’s the same case with pensions.
These can get tax relief – but as you’re self-employed, you’ll need to set one up yourself. For basic rate taxpayers, every £100 you put into your pension is topped up with an additional £25 by the government. This does rest on you declaring these contributions on your Self Assessment tax form though.
And if you’re paying at the higher rate of 40%, then there is an extra £25 on top of this to claim. If you’re in Scotland, the situation is slightly different, as the higher rate is 41%, you can instead claim £26.25 for every £100 put into your pension.
Whilst the amount of potential tax relief is substantial, it is capped. There is an annual allowance per year – for 2018/2019, only pension contributions up to the value of £40,000 can be claimed on. Any additional money that is put into your pot beyond this figure won’t give you a tax benefit. If you haven’t claimed when you should have during the previous three years, it can usually be backdated.
Set up an ISA
An Individual Savings Account (ISA) is another answer to the question ‘how to reduce my tax bill if I’m self-employed?’ There are four different types available, all of which you can save into each year. The limit for the amount of money saved collectively is £20,000 per year, and the Lifetime ISA also has a cap of £4,000.
The latter is one that many self-employed workers find appealing because the government adds 25% onto the amount you save. If you take advantage of the full £4,000 each year, you’ll have £5,000 before even taking into account the interest you’ll earn on top of that. Lifetime ISAs can’t be contributed to for an actual lifetime though – they can only be used from age 18 to 50.
A stocks and shares ISA is another attractive option. There is no Capital Gains Tax on profits, which is beneficial to those who sell assets totalling over £11,700 in a given year. In addition, you don’t have to pay tax on the interest earned on bonds, or the dividend income.
Use tax return software
These aren’t the only tax-saving methods – there are even more, like taking advantage of the self-employed personal tax allowance. Whilst these ways will help reduce your tax bill, working out the figures might not be your speciality. It doesn’t matter how many times you’ve cross-referenced your receipts, there’s always a chance you might have missed something.
Thankfully, the best tax software can pinpoint any errors so you can rectify them accordingly and send a faultless form to HMRC. Self Assessment software can also help you to identify any potential savings that were missed the first time around, further reducing your tax bill.
Our GoSimpleTax software asks the right questions according to your occupation and provides sage advice as you go, ensuring accuracy from start to finish. You’ll be able to see your tax owed in real time, meaning you’ll always have access to the full picture of your tax situation.
Sample GoSimpleTax today with a 14-day free trial and start cutting significant costs by reducing your tax bill.