You’ve probably searched for this article to determine whether you should become self-employed or stay employed to pay the least amount of tax possible, right? Well, luck for you, I’ve provided this advice to a fair few people and this is what I’ve found.
Using an example of £40,000 salary/profits a year – an employee would pay the most tax at around £9,300 for the year. In comparison, a Sole Trader would pay approximately £8,400 in tax and a Limited Company would pay £7,300. This is based on several assumptions and using tax rates relevant to the current tax year.
Now, obviously there are a few things that impact the amount of tax you pay so let’s take a more comprehensive look into these different factors so you can decide whether you’ll pay tax as self-employed or employed.
To underpin our whole article, let’s have two examples which we can apply to each scenario (employed or self-employed) so we can see how the amount we are earning (and from where) affects the amount of tax we pay under each choice.
Example 1:
Rodger – he works for himself and is deciding whether to stay as Sole Trader or become a Limited Company. He is an electrician by trade and earns around £40,000 in profit from his business.
Example 2:
Joe – he’s an average guy (an average Joe, if you please) and he is an electrician who works for a large multinational company. His salary is £40,000.
(Notice how we’ve set ourselves up with two guys who both earn £40,000 but one is employed and the other self employed? Smart right?)
Self employed
So with this route, we’ve got our friend Rodger. He earns £40,000 as a Sole Trader and is considering whether to become a Limited Company. Let’s take a look at how much tax he should be paying as a Sole Trader and how much he should be paying if he starts trading under a Limited Company.
Sole Trader tax
We’ve already mentioned his trading profits are £40,000 so this is what he pays tax on.
So we’ve got a few different taxes he’ll have to pay out – first of all, National Insurance.
National Insurance
There are a few different types but for Sole Traders, the types he’ll have to pay are Class 2 and Class 4.
Class 2 national insurance is calculated at £3.05 per week. Over a period of 52 weeks (for the year), he’s looking at paying £158.60 in Class 2 national insurance.
Class 4 is calculated at 9% on profits between £9,569 and £50,270. So if we deduct this £9,569 from our £40,000 profit, we have to pay Class 4 national insurance at 9% of £30,431 – this equals £2,738.79.
So our total tax bill solely for national insurance is £2,897.39.
Income Tax
Now we move onto the big one – Income tax. This is the bane of everyone’s life but is necessary nonetheless.
Income tax is calculated by reducing your income by your personal allowance (£12,570) and multiplying by 20%, 40% and 45% depending on the level of your earnings.
For Rodger, he’s earned himself £40,000 which means he will need to pay tax on £24,430 of it (as we’ve deducted his personal allowance). As he’s not a higher rate tax payer, he’ll only need to pay tax at 20%.
His income tax bill is 20% of £24,430 which equals £5,486.
Final Sole Trader tax bill
Based on our workings, Rodger, as a Sole Trader, will need to pay a total of £8,383.39 in tax (£2,897.39 as national insurance and £5,486 as income tax).
Limited Company tax
Now, you can be quite clever with your taxes when you’re looking at some simple personal tax planning. You can utilise your limited company and your position as the sole shareholder within it.
By giving yourself a salary that is equal to the personal allowance limit, you can deduct this as a taxable expense from your business. You will then pay Corporation Tax at 19% on the remaining profit and pay yourself the rest out as dividends.
Sounds a little complex so let’s jump into it.
Salary from Limited Company
Rodger runs his business through a limited company and earns himself £40,000 as profit. He now gives himself a salary of £9,568. This looks a bit weird because it’s less than our personal allowance – so what gives?
This is actually the threshold for National Insurance. So if we earn anything more than this amount, we won’t need to pay income tax but we will have to pay National Insurance – which is 12%.
If we deduct this from our £40,000 profit – we’re left with profits of £30,432 left to be taxed in the company.
Taxes on Limited Company profits
With a final profit to tax of £30,432, you need to pay Corporation tax (CT) and National Insurance, not ideal.
First, let’s take a look at the CT you need to pay. CT is charged at 19% – this means that £5,782.08 is due in this respect.
This leaves you with £24,649.92 as money you can withdraw from your company after you’ve paid the CT.
Withdrawing money from the Limited Company
So how do we get that £24,649.92 into our pockets? We need to vote this as a dividend. Dividends are taxed at a much lower rate than income is so this is why it’s so beneficial running this through a company.
The only issue is, you must be completely independent (not relying on another company to employ your services) otherwise this is inside the scope of something called IR35 which means you’re not allowed to use a Limited Company.
Dividends are taxed at 7.5% and there’s also a lovely little £2,000 dividend allowance that means the first £2,000 you receive as dividends is tax-free – NOICE!
When withdrawing the remaining £24,649.92 – you need to remember you didn’t use all £12,570 of your personal allowance! So when we’re working out the amount to tax at 7.5%, we need to deduct our dividend allowance (£2,000) and our remaining personal allowance (£12,570 – £9,568 = £3,002).
This gives us a final taxable figure of £19,647.92 at 7.5% which equals £1,473.59.
Final Limited Company tax
Ok great – so now we’ve managed to trudge through those workings, we need to bring everything together to see how much tax Rodger would pay on his £40,000 if he were operating as a Limited Company.
- Tax on salary – £0 (as under the NI threshold);
- CT on profits – £5,782.08; and
- Tax on dividends – £1,473.59
Final tax bill equals – £7,255.67.
When comparing this to the Sole Trader tax bill (£8,383.39), it would actually be £1,127.72 cheaper in tax to run the Limited Company!
Employed
After all of that, we’ve determined that the most tax-efficient option for a self employed individual earning £40,000 is to run a Limited Company. But how does that weigh up against our pal Joe who is employed with a salary of £40,000?
National Insurance
This is similar to the Sole Trader national insurance, however as Joe is an employee – he pays a different class of national insurance. Employees pay Class 1 national insurance which is 12% on anything above £9,568.
For Joe, he earns £30,432 above this threshold and therefore needs to pay £3,651.84 of national insurance on his salary for the year.
Income Tax
Finally, Joe needs to pay income tax on his salary. He needs to first account for his £12,570 personal allowance before applying the 20% tax rate to the remaining salary.
After deducting his personal allowance, Joe has a taxable income of £27,430. Taxed at 20% means he needs to pay £5,486 in income tax.
Final employment tax
If we add all of the tax payable for national insurance and income tax, Joe’s final tax bill is £9,137.84.
It may sound like a lot to stump up at once but as Joe is being paid monthly via his employer’s PAYE (Pay As You Earn) scheme, this tax is deducted automatically on a monthly basis.
This means Joe can spend whatever he receives into his bank without worrying about any tax filings and payments due.
Final Roundup
So there we have it!
Based on profit/salary of £40,000 a year, you would pay approximately:
- £8,383.39 as a Sole Trader;
- £7,255.67 as a Limited Company; and
- £9,317.84 as an employee.
However, although it looks like the most tax efficient option is a Limited Company – this is only applicable for the example of £40,000 – as earnings grow, tax rates change and allowances taper off so it’s a completely different picture at different earning rates!
I’ve also made the assumption that this is the sole income being earned – if you are an employee AND a Sole Trader for your own side business, things also change.
This should give you a good idea of the different types of tax each scenario pays and what sort of tax is paid by those earning around the £40,000 mark per year.