With some five million people working for themselves in the UK, and around twice that number in the US, self-employment is a popular career path.
If it’s one you’re considering, you’ll need to account for the financial responsibility you’re taking on, so in this article, we’ll cover all you need to know about self-employment tax.
What Is Self-Employment Tax?
When you work for a business or organization, your employer ensures all relevant deductions are applied to your earnings. When you work for yourself however, you’re responsible for your own self-employment tax.
This is the tax you pay on your profit – that is, your annual income minus any reasonable expenses. It is paid to HM Revenue and Customs (HMRC) in the UK, and the Internal Revenue Service (IRS) in the US.
Anyone classed as a freelancer, contractor or sole trader whose profits exceed their personal allowance must pay this tax. In the UK, the personal allowance for most people stands at £12,570 for the 2021/22 tax year. In the US, it is currently $12,550.
The process differs if you’re listed as director of a limited company. In this instance, the legal entity that is your business will be subject to corporation tax, and you yourself will be classed as an employee for tax purposes, taking home an annual salary minus income tax deductions.
It’s likely you’ll also draw dividends from company profits, on which you’ll pay personal tax each year through your self assessment tax return.
It’s worth noting here that self-employment tax is separate to Value Added Tax (VAT) – the tax levied on products and services. This is paid through your VAT return if, as a sole trader, you choose to become VAT registered.
Why Is It Important to Be Aware of Self-Employment Tax Regulations?
As a self-employed person, you reap the benefits of this career choice, like flexibility and working from home, but you also take on financial liability, and if you’re unsure of the rules there can be costly consequences.
It is your legal obligation to ensure you file your self assessment on time and pay any tax owed. If you fail to do so, or do so late, you may face a fine.
That fine is currently £100 in the UK for tax returns filed up to three months after the deadline, rising incrementally the longer the delay. You’ll also pay a fine if you fail to pay your tax bill on time, as well as interest until your balance is cleared.
The IRS applies percentage penalties. You’ll be charged 5% of tax owed for every month your return remains unfiled, and if filing 60 days past the due date you’ll pay a fine of $435 or the full equivalent of tax owed, whichever is the lower amount.
Not only is it important to be aware of self-employment tax, you also need to ensure full compliance by keeping accurate financial records.
If an anomaly is identified in your tax return you may well be subject to an audit. The investigating authority will want to see evidence of all financial transactions associated with your work, and if you don’t have them you could face legal proceedings.
Ultimately, the implications of failing to comply can be damaging, not to mention that you could be caught out by a hefty bill if you don’t get to grips with self-employment tax regulation.
Do You Get Taxed More if You’re Self-Employed?
This depends on the country in which you reside. In the UK, self-employment tax is on par with the tax paid by employees. The situation in the US however is somewhat different.
Below you’ll find an overview of the taxes you should expect to pay as a self-employed person in both the UK and the US.
What You’ll Pay – UK
Self-employment tax in the UK is made up of income tax and National Insurance (NI):
Income tax – The amount you pay in income tax does not change regardless of whether you’re employed by a business or work for yourself. The rates for the 2021/22 tax year are as follows:
Basic rate – If your profit is between £12,571 and £50,270, you’ll pay 20%.
Higher rate – If your profit is between £50,271 and £150,000, you’ll pay 40%.
Additional rate – If your profit exceeds £150,000, you’ll pay 45%.
National Insurance – Compared to employees, the self-employed actually make lower NI contributions. NI is split into Class 2 and Class 4, and what you pay will depend on your profitable income:
Class 2 – If you earn between £6,515 and £9,568 you’ll make Class 2 contributions, charged at a weekly flat rate of £3.05.
Class 4 – If your income exceeds £9,568 you’ll also make Class 4 contributions charged at 9% on profits above the threshold up to £50,270, and 2% thereafter.
Again, these rates are based on the 2021/22 tax year and are subject to change.
What You’ll Pay – US
Self-employment tax in the US is separate to federal and state income tax. As well as paying the latter, you’ll also pay the former, which is made up of Social Security and Medicare, at a combined rate of 15.3%.
Employees on the payroll pay half of this, with the other half paid by their employer, so 7.65% paid by each party.
When you’re self-employed, you’ll have to stump up the full 15.3% yourself throughout the year, but can claim half as deductible from your income tax when you file your Form 1040 (we’ll explain more on this later).
Social Security – This accounts for 12.4% of your self-employment tax. However, it is only applied to a portion of your profitable income – the first $142,800 in 2021.
Medicare – This applies to all your profitable income, and makes up the remaining 2.9% of self-employment tax. If you earn over $200,000, you may be subject to an additional 0.9% tax for Medicare.
What Do You Need to Know to Get Started?
The guidance below refers specifically to self-employment tax.
For broader advice on working for yourself, read our comprehensive guide on how to become self-employed.
How and When to Submit Your Tax Return
You’ll need to tell HMRC that you’re self-employed and register for self assessment. You’ll need your National Insurance number to do this.
When you register, you’ll receive a Unique Taxpayer Reference (UTR), a 10-digit code that identifies you for tax purposes.
You’ll also set a 12-month accounting period – the timeframe in which you wish your tax to be calculated. For ease, many people align their accounting period with the tax year, which runs from April 6th to April 5th.
The deadline to submit your tax return is October 31st if filing a paper return, or January 31st if filing online. You must also pay your tax in full by January 31st.
So for example, tax owed on profits made in the accounting period between April 6th 2021 and April 5th 2022 must be paid by January 31st 2023.
Another thing you need to be aware of are payments on account. These are often applied after your first full year of business, and are estimated payments for the year ahead.
They’re based on your previous taxable income and split into two installments, one made in January and another in July.
As an example, say you file a return for 2021/22, paying £8,000 in tax. If you’re asked to make a payment on account, you’ll need to pay an additional £4,000 on January 31st and £4,000 on July 31st. Payments will be reconciled when you file your 2022/23 return.
This system is designed to ease the burden of paying all your taxes in a lump sum and works well once you’re in the flow of things – but it’s also something that trips a lot of people up the first time round.
Self-employment tax in the US is quite a complicated process. The tax year runs from January 1st to December 31st, and anyone operating as a sole proprietor must file a Form 1040 by April 15th following the end of the tax year.
Form 1040 covers income tax, and you’ll need to submit an accompanying Schedule SE for your self-employment tax. If this exceeds $1,000 per year, you’ll be required to make estimated payments on a quarterly basis.
The tax year is split into the four payment periods of January to March, April to May, June to August and September to December. Estimated payments for each period must be made by around the 15th of the month following the end of the quarter. For example, for the period between January to March, the payment deadline falls in April.
So, as we mentioned earlier, you’ll pay 15.3% each quarter, but can claim half of this as deductible when you come to file your Form 1040.
To complete your tax return, you’ll need your Social Security number. If you’re ineligible for a Social Security number, you’ll need to apply to the IRS for an individual taxpayer identification number (ITIN).
How Much to Put Aside?
When you’re self-employed, a good rule of business is to start putting money aside for taxes from day one, and always overestimate.
It can be hard to project your income, particularly if you’re just starting out or your work is unpredictable, but erring on the side of caution is the best way forward.
Use your country’s self-employed tax rates as a guide and add a little on top for a safety net. Remember, you may need to make estimated payments throughout the year, so it’s always handy to have reserves in the bank.
How to Ensure Compliance
It’s not just filing your tax return and making payments that you need to keep on top of. You also need to maintain auditable financial records in case of an investigation.
Keep paper and/or digital copies of all incoming and outgoing transactions – invoices, bills, receipts, bank statements – anything related to the financial activity of your self-employment. Make sure these are dated and filed in a logical order.
You’ll need to keep these records for a minimum duration after the tax year they apply to, five years in the UK and four in the US, but again it’s always better to err on the side of caution.
To make bookkeeping easier, consider investing in accounting software, and of course you should always seek professional assistance where necessary.
Can I Reduce How Much Tax I Pay?
As mentioned, self-employment tax is charged on your profit, not your turnover, so to lower your tax bill make sure you claim for all allowable expenses.
An allowable expense is classed as anything you need to run your business or carry out tasks relating to it.
This includes equipment, office supplies, marketing costs, business-related travel and accommodation, property rental – essentially anything that is a justifiable requirement.
Be careful with anything used for both business and personal purposes, like mobile phones and vehicles. In these cases you must only claim for business use, and must be able to prove as such with your records.
There are also tax deductions to be had if you work from home. Here you can claim a percentage of utility bills, rent or mortgage interest and property/council tax.
To calculate what you can claim, you’ll need to work out what percentage of your home’s square footage is used for business, and then work out the equivalent percentage of your bills.
If that sounds like too much of a headache, both countries offer simplified expenses for use of home using a flat rate. In the US, you can claim $5 per square foot of your office space. In the UK, it’s a tiered rate depending on how many hours you work from home, with a maximum allowance of £26 per month.
If you can afford to do so, making substantial pension contributions is another way to lower your self-employment tax bill.
How to Calculate Your Tax Payments
Below you’ll find two simple examples of how to calculate your self-employment tax, one based on the UK system, and one on the US.
Example 1 – UK
For this example, we’ve taken an annual turnover of £30,000, with £2,000 of expenses:
Turnover: £30,000 Expenses: £2,000 Taxable earnings: £28,000
Class 2 NI at £3.05 per week: £158.60 Class 4 NI at 9% on £18,432 (£28,000 – £9,568): £1,658.88
Income tax at 0% on £12,570: personal allowance Income tax at 20% on £15,430: £3,086
Total self-employment tax: £4,903.48
Example 2 – US
For this example, we’ve taken an annual turnover of $85,000, with $15,000 of expenses:
Turnover: $85,000 Expenses: $15,000 Taxable earnings: $70,000
Social security at 12.4%: $8,680 Medicare at 2.9%: $2,030
Total self-employment tax: $10,710
What Help Is Available?
Self-employment tax can be daunting, but it is an essential part of working for yourself. If you’re unsure of what the requirements are, seek guidance from the relevant authority.
Both the HMRC and the IRS have plenty of useful resources online to help you navigate the waters of your self assessment tax return.
Both also offer guidance on how to ensure compliance, such as documentation on what can be passed as a reasonable expense.
We mentioned accounting software earlier on, and this can prove a cost-effective option for keeping your books up to date. These platforms are often automated, connecting to your business bank account and logging all transactions. They also allow you to upload documentation like bills and receipts, so you can keep all your records organized.
Some even offer the option to file your return using the software, and pre-populate many of the required financial details. You will of course need to check over this carefully before submission.
If your business accounts are complex, it’s advisable to invest in professional bookkeeping or accounting services. If you don’t require year-round assistance, it’s a good rule of thumb to at least have a qualified accountant check over your self assessment.
Match your support to your budget and the complexity of your finances.
It’s rare to find anyone in self-employment who enjoys doing their taxes, but unfortunately, it’s a legal requirement and par for the course.
The best advice we can offer is to be proactive. It might be tempting to ignore your accounts until absolutely necessary, but this will only result in increased stress come tax time.
In making time to ensure your books are intact, and setting aside part of your income each month, you’ll avoid the last-minute headache and the consequences of failing to comply with self-employment tax regulation.