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A Contractor’s Guide to Tax
You don’t have to be new to the self-employed to find contractor tax confusing. Even the most experienced contractors can be overwhelmed by the different rates, allowances and types of tax.
With expenses, percentages and different tax bands to cater for, there’s a lot to take into account when working out what you owe. And, with it being such a hefty annual figure, it’s an important thing to work out well in advance to ensure you don’t get caught out at the end of the financial year.
For clear and straightforward advice, read on as we break down everything you need to be aware of when it comes to contractor tax.
Do contractors pay tax?
Often in the media, contractors are portrayed as having little or no tax requirements. Unfortunately, that’s not the case. All contractors face similar tax requirements on their earnings to those who are employed.
Contractor tax rates
Similar to those who are employed, contractors are not required to pay any income tax rates on earnings up to £12,500. However, once you hit that threshold, tax rates will increase to the basic rate which is 20% of profits.
Once earnings reach £50,000 a year, contractors will be on the higher rate which totals 40% of revenues. If you’re lucky enough to earn anything over £150,000 per annum, the additional tax rate reaches 45%.
What’s important to note is that these rates only apply to earnings within that threshold. So, somebody earning £160,000 a year will only have the top £10,000 taxed at 45%, £100,000 taxed at 40%, £37,500 at 20% and will still get their first £12,500 tax free.
Contractor National Insurance rates
When considering contractor tax, it’s also essential to take into consideration the rates of National Insurance. For anyone earning over £6,365, Class 2 NI rates will be applicable, costing £3 per week.
Once you reach earnings of £8,632 or over, you’ll then be paying Class 4 NI rates. This will be 9% on profits up to £50,000, and 2% on earnings over that.
Tax allowances for contractors
Despite having to pay standard tax rates, contractors do get to benefit from certain allowances.
Like a normal employee, the first £12,500 of your earnings will always remain tax-free. This means that you only pay tax on earnings after that, even if your total earnings put you in the basic rate or higher rate tax bands.
As a contractor, you’ll likely encounter plenty of additional working costs. Luckily, some of those costs will be deductible when working out your taxable profits.
These costs can include:
- Office expenses, such as phone bills and stationery
- Travel costs such as parking and petrol, but not including commuting
- Staff costs which will be applicable if you hire subcontractors to support your work
- The cost of running a business premises, including bills, or renting a desk
- Training fees
- The cost of advertising and marketing
Before working out your tax at the end of the year, always consider these expenses as they can work out to be very beneficial. However, always keep a record of invoices and receipts as you will have to provide proof of purchase should Her Majesty’s Revenue and Customs ask for them.
Limited companies and tax
Quite a few contractors choose to work as limited companies rather than self-employed contractors. This is because it can be more tax-efficient depending on the individual circumstances, can present a professional image to clients and can reduce risks associated with IR35.
However, before operating as a limited company, you’ll want to be fully aware of the different types of tax that will be payable each financial year.
As a limited company, you will have to pay Corporation Tax. This is a rate of 19% on all earnings over £8,632. Below that threshold, profits will be tax-free. Depending on where you stand with IR35, you will pay yourself a low salary, but combine it with dividends. All wages are tax-deductible while dividends are payable from the company’s profits after-tax.
Employer National Insurance Contributions
As you will be paying yourself a salary, a limited company will also have to pay Employer’s National Insurance Contributions. The cost of this is based on gross salary and will apply to earnings of over £166.01 per week. The fee will then be payable either monthly or quarterly as part of the company’s NIC or PAYE bill.
Value Added Tax (VAT)
Whether you’re a limited company or a sole trader, anyone with turnover exceeding £85,000 must register for VAT. That means you’ll have to add 20% onto any invoice given to a customer. HMRC will then collect this on a quarterly basis. It shouldn’t affect business too much, as most companies paying you will also be VAT registered, so they can claim back the cost of VAT through tax relief in their expenses.
Filing your tax returns
Once you’ve worked out your profits for the year and calculated your tax requirements, you’ll then have to submit your tax return. If you’ve never sent one before, you will first have register for self-assessment.
When you’re ready to submit your return, you’ll need your Unique Taxpayer Reference code and your NI number. You’ll also need to gather details of all income, records of expenses and bills as well as anything relating to things such as pensions where you can claim tax relief.
The primary section of the tax return is SA100 and will require details of all income, pension contributions, charitable contributions and benefits.
You’ll then come on to SA103 which is for those who are self-employed. Here, you will have to enter your total income for the year and declare your expenses. If your income is under £85,000, you’ll be able to enter the total cost of your expenses. However, if your income is above the threshold, you’ll have to enter individual totals for each category of expense.
Umbrella companies and tax
Umbrella companies can simplify contractor tax by a great deal. As they will be acting as an employer, all you need to do is submit your timesheets to them and let them know what work you have completed over the month.
They will then take care of the invoicing process before working out all of the related fees, including National Insurance and tax. They’ll make sure this is taken care of, before paying you a take-home salary.
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