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Income Tax Explained For Sole Traders

Navigating the world of income tax can be daunting, especially for sole traders with no colleagues to turn to. Whether you’ve recently ventured into self-employment or have been flying solo for a while, understanding your tax obligations is crucial. In this blog, we’ll simplify income tax for sole traders, helping you gain clarity and confidence in tackling your tax head-on.

Who is a Sole Trader?

First and foremost, let’s understand what it means to be a sole trader. A sole trader is an individual who runs their own business and is considered self-employed. Unlike limited companies, sole traders don’t have a separate legal identity from their business. This means the business’s profits and losses directly affect the individual’s finances.

Income tax basics

Income tax is the tax you pay on your earnings. For sole traders, this means the turnover you make from your business minus allowable expenses. The amount you owe is calculated annually through the Self-Assessment tax system.

Every year, by the 5th of October for paper returns and the 31st of January for online returns, sole traders must complete and submit a Self-Assessment tax return to HMRC. This outlines your earnings and expenses for the previous tax year (from 6th April to the following 5th April).

Allowable expenses

One advantage of being a sole trader is that you can deduct certain costs, known as “allowable expenses”, from your turnover before tax. Common allowable expenses include:

  • Office costs (e.g., phone bills, stationery)
  • Travel costs (e.g., fuel, public transport)
  • Clothing expenses (e.g., uniforms)
  • Staff costs (e.g., salaries, freelance work)
  • Things you buy to sell on (e.g., stock, raw materials)
  • Financial costs (e.g., insurance, bank charges)
  • Advertising or marketing (e.g., website costs)

Remember to keep a detailed record of these expenses, as HMRC may ask you to prove them.

How much income tax do I pay?

The amount of self-employment tax you’ll pay depends on your income and any business expenses. The government allocates a personal allowance, which is the amount you can earn tax-free in a financial year. For the 2023/24 tax year, the personal allowance is set at £12,570*.

But once you’ve exceeded your personal allowance, you’ll pay tax on your income earned above this at the following rates:

  • Basic rate: £12,571 to £50,270 – 20%.*
  • Higher rate: £50,271 to £125,140 – 40%.*
  • Additional rate: Over £125,140 – 45%.*

For instance, if you made a profit of £40,000 (after deducting allowable expenses), you’d owe no tax on the first £12,570 and 20% on the remaining £27,430.

How do I pay my income tax?

Being self-employed, you’ll pay tax on your sole trader profits through the government’s self-assessment scheme. This means completing a self-assessment tax return and submitting it to HM Revenue and Customs (HMRC) annually.

The deadline for submitting your online self-assessment tax return is 31st January of every year. It’s important to note that, if you miss the deadline, you could be liable for a penalty.

Sign up or sign in and file your Self Assessment tax return here.

Payments on Account

This is a system used by HMRC to collect tax in advance from those who owe tax from the previous year. If your tax bill from the previous year was over £1,000 and only a small amount was deducted at source (e.g., from wages or pensions), you’d likely have to make “payments on account”.

You make these payments in two instalments: by midnight on 31st January (covering the first half of the tax year) and 31st July (covering the second half). Each payment is half of your previous year’s tax bill.

What if I make a loss?

If your business makes a loss, as some sole traders do, the loss is carried forward to the following financial year and used to offset future profits. The result is you won’t have to pay tax on any future profits until you’ve recouped the loss of the previous year.

National Insurance

As well as income tax, sole traders also need to pay National Insurance contributions. There are two types relevant to sole traders:

  • Class 2 National Insurance: A flat weekly rate of £3.45 if your profits are £12,570 or more a year (for the 2023/24 tax year*). Even if your profits are under the threshold, it’s a good idea to keep paying your Class 2 National Insurance to make sure you qualify for certain state benefits, including the state pension.
  • Class 4 National Insurance: 9% on profits between £12,570 and £50,270
    2% on profits over £50,270 (for the 2023/24 tax year*)

Tips for managing your taxes

  • Stay Organised: Keep a detailed record of your income and expenses. Use accounting software or hire an accountant if necessary.
  • Save Regularly: Put aside a percentage of your income for taxes to avoid a last-minute scramble.
  • Stay Updated: Tax rules and rates can change. Regularly check the HMRC website or speak to your accountant.

So, while income tax obligations might seem overwhelming at first, understanding the basics is the first step to efficient and stress-free tax management for sole traders. With organisation, diligence, and possibly some professional guidance, you can master your taxes and focus on running your business.

If you still have questions about taxes as a sole trader or need a hand to complete your tax return, get in touch or contact us online here. Don’t forget – we’re all about tax returns with stress deducted. 

* Remember, these figures can change annually based on government decisions