How to pay yourself as a sole trader tax efficiently

How to pay yourself as a sole trader

How to pay yourself as a sole trader

Since business turnover is different from taxable profit (on which tax must be paid at the end of the year), haphazardly drawing money from your business is inadvisable.

You should separate business income from personal funds and allocate a portion of your earnings to a separate savings account to pay your tax.

As a sole trader, CloudCo will be pleased to advise you on how to pay yourself. With our amazing cloud-based accounting software, we’ll ensure you claim all the allowable expenses and tax reliefs and prevent any errors in your bookkeeping and accounts. Get in touch with us today.

Is there a tax-efficient way to pay yourself as a sole trader?

Being organised and transparent is the basis of running any business tax efficiently, whether you’re a sole trader or limited company business.

  • Open a separate business bank account and issue all your business invoices for payment to this account;
  • Open a savings account to hold around 25% of your net income each month so you have money set aside to pay your income tax and National Insurance (NI) contributions at the end of the tax year;
  • Pay business-related expenses from your business account;
  • Pay yourself a set amount each month from your business account into your personal account. This is much better than plundering your business bank account through random personal purchases.

Maintaining a business bank account and a personal bank account makes the task of accurately recording your income and expenses on your self-assessment tax return a lot easier. HM Revenue and Customs (HMRC) also prefer the transparency of this organised approach by sole trader businesses.

Paying a percentage of your income each month into a separate saving account to cover your tax, and NI will earn you interest on the money until it’s time to pay your tax bill.

Other tax-efficient ways to pay yourself as a sole trader include using the available tax reliefs such as paying into a pension fund, building up tax-free savings with an ISA, and using your savings allowance.

Building up a pension fund means that you will benefit from pension tax relief. You deduct pension contributions from your gross pay prior to any tax deductions. This means paying into a pension scheme can reduce your taxable profit (e.g., if you turnover £50,000 p.a. but pay £10,000 into your pension, your taxable profit becomes £40,000). Bear in mind that pension contributions cannot be included as a tax-deductible expense on your SA tax return; your contributions should go in the “tax reliefs” section of your tax return.

An ISA is another way to build up tax-free savings for your future. The tax on lifetime ISAs and pensions differs: a pension is tax-free when you pay into it (with tax relief on the whole contribution), but tax is due when you withdraw money from it. With a lifetime ISA, you contribute money you’ve already paid tax on, but eligible withdrawals are tax-free. Some tax-planning advice from an accountant could be useful here to determine which option is the best suited to your circumstances. Again, you will record this in the “tax reliefs” section of your tax return.

The savings allowance means an amount of interest on your savings is tax-free. This relates to bank and building society accounts, trust funds, life annuity payments, some life insurance contracts, company bonds, savings accounts, and similar products. For basic rate taxpayers, this allowance is £1,000 and £500 for higher rate bands.

How to calculate a sole trader’s pay

Before you work out what to pay yourself, you could estimate what you will be liable to pay in income tax and National Insurance contributions based on your profit. You can calculate what your bill is likely to be by using the online HMRC SA tax estimate tool. But in 2024, remember that the tax bill you will be paying is based on the previous year’s profits. Income can fluctuate; hence, keeping organised business records, bookkeeping, accounting, and some sort of tax planning are vital.

Benchmarking is a useful way to decide what to pay yourself. You can check out the salary scales for other workers fulfilling your role in similar industries and pay yourself accordingly, depending on your business turnover. You should bear in mind that HMRC uses benchmarking to spot-check the accuracy and honesty of the information taxpayers give on their SA tax returns.

As far as the law is concerned, sole traders are not legally separate from the business. They receive the income and pay any expenses, are liable for any debts, and are required to pay personal income tax. The annual profits of a sole trader business are calculated by taking the total annual turnover of the business and subtracting its business-related expenses, bills (e.g., rent, gas, electricity), travel costs, annual pension contributions, etc.

Income tax

Keeping abreast of the current income tax and National Insurance rates is important. The rates change from time to time, and if you’re working out your own income tax it’s up to you to stay up-to-date with any changes.

You will pay tax on your profits, that is, after expenses have been subtracted. So, if your turnover is £60,000 and your expenses (with relief and allowances) add up to £20,000, your taxable profit will be £40,000. Don’t forget your personal allowance of £12,570, for which no tax will be due, so your taxable profit will be £27,430. You will pay tax at 20% on this sum.

Tax brackets 2024/25

  • Up to £12,570 (personal allowance) 0%
  • £12,570–£50,270 (basic rate) 20%
  • £37,701–£125,140 (higher rate) 40%
  • Over £125,140 (additional rate 45%

National insurance contributions

Sole traders pay Class 2 and Class 4 NI contributions via their SA tax return if profits from their business reach £6,725 or more annually.

Even though you won’t have to pay NI on your profits if they are below £6,725 annually, it’s advisable to make voluntary Class 2 NI contributions if you can, to maintain your NI record and ensure you receive a full state pension and other state benefits. In 2024/25, the weekly rate for Class 2 NI contributions is £3.45.

After the £6,725 threshold, your Class 2 contributions are protected to safeguard your NI record, and no additional payment is required. But, if you earn over £12,570 per year, you are legally obliged to pay Class 4 contributions.

These are:

  • 6% on profits from £12,570 to £50,270
  • 2% on profits over £50,270

This means that on £27,430 profit, you will pay Class 4 NI at 6%.

Do sole traders get dividends?

No, unlike limited company shareholders, a sole trader does not receive dividends from their own business. This is because sole-trader businesses do not have shareholders. However, if you hold shares in another company, you might receive dividend payments, which should be reported on your personal tax return.

Sole traders pay income tax on their profits, which is why the sole trader business model is seen as less tax efficient than operating a business as a limited company. Limited company business owners tend to keep their salary or wages below the higher rate income tax threshold and take the rest of their salary in dividends, which are taxed at a lower rate provided the amount remains below the higher rate dividend threshold.

You should speak to a qualified accountant if you would like to find out more about converting your sole trader business to a limited company. It may make sense, but it may require further administration, which might mean hiring an accountant. However, bookkeeping and accounting fees are fully tax-deductible.

How to draw money from your business account

It is mandatory for sole traders to keep records of both their business and personal income. Unlike limited companies, sole traders are not legally considered financially separate from their businesses, allowing them to theoretically draw money from the company and pay themselves as they please. However, these “drawings” (withdrawals) must be transparent, organised, and up to HMRC scrutiny should they request access to your accounts.

Your profit is the surplus you have available after you’ve deducted allowable expenses from the income you’ve earned. As a sole trader, you draw money from your business income to pay yourself. Using a business bank account makes separating business expenses from personal expenses much easier, but it also helps by showing how much money you have withdrawn from business profits as “wages”. HMRC likes to see your personal and business finances kept separate, in order, and transparent.

Keeping a record of these business account drawings is much easier when your bank statement clearly shows that you moved funds from your business account into your personal account. Since you must record your business expenses and income and show what you paid yourself as wages, it is far more transparent if you can show the transactions in one place.

With your wages, the transaction will be easily identifiable on your business and personal bank statements. You can see clearly when the money left your business account and arrived in your current account, and it’s even clearer if you use a reference such as “wages” or “salary.”

Separating your personal finances from your business finances in two accounts simplifies the process of reconciling your invoices with your bank statements, calculating your earnings, identifying unpaid bills or expenses, determining your wages, and completing your SA tax return at the end of the tax year.

You should avoid using your business debit or credit card for personal expenses. Keeping track of the amount you’ve spent from your business, along with where and when you made the purchases, becomes easier when your business bank statement primarily reflects business-related transactions.

If you use a personal card to pay for a business expense, then these incidental expenses through your personal account are fine. You can still allocate it as a business expense, so long as it was “wholly and exclusively” for business purposes.

Keeping a record of all drawings, income, and expenses is your legal duty as a sole trader. Your bookkeeping will take an awful lot less time if the transactions on your bank statement are not a mixture of personal and business outgoings in one account. If you mislay your personal bank card or forget to take it with you, you can make the occasional payments for personal use through your business account, but you must not record it as a business expense unless it is one.

Never forget that you will need to pay your taxes and NI contributions. Open a separate savings account to hold a portion of your monthly earnings each month. Psychologically, this is good practice because you don’t go around thinking all the money in your business bank account belongs to you because it does not. Treat the money in your personal account as “your” money and treat the money in your business account as the business’s money. The money set aside in your savings account will earn interest until you pay your taxes.

What expenses can sole trader claim?

As a sole trader, your business will have various running costs. You can deduct these allowable expenses from your profits before tax. Remember, allowable expenses are those that are “wholly and exclusively” for the purposes of running your business and do not include private purchases.

For example, if you buy a hairdryer, you must show (should you be asked by HMRC) that you are a hairdresser or fashion stylist or have some other legitimate reason for purchasing the item for your business. Similarly, if you enrol in a six-week course in German at the Goethe Institute, you must be able to show that the German language is integral to operating your business.

You can check the list of allowable expenses on the HMRC website, but the following provides the basic rules on claiming expenses as a sole trader:

Allowable expenses include:

  • office costs, e.g., stationery or phone bills
  • travel costs, e.g., fuel, parking, train, or bus fares
  • clothing expenses, e.g., uniforms
  • staff costs, e.g., salaries or subcontractor costs
  • things you buy to sell on, e.g., stock, or raw materials
  • financial costs, e.g., insurance or bank charges
  • costs of your business premises, e.g., heating, lighting, business rates
  • advertising or marketing, e.g., website costs
  • training courses related to your business, e.g., a refresher courses

Expenses cannot be claimed when using the £1,000 tax-free “trading allowance”.

Capital allowances can be claimed for business-related items such as equipment, machinery, and business vehicles. However, they cannot be claimed when using the £1,000 tax-free “trading allowance”. There is also a rule based on the accounting system you use.

Splitting private from business use to work out a business expense

You can only claim allowable expenses for the business costs. For instance, if you use your mobile phone for both personal and business purposes, you should only claim expenses related to business use. For example, if your annual mobile phone bill is £200, £130 of which is for personal calls, you can claim £70 for business use.

If you work from home, you could apportion the expense for things like heating, electricity, council tax, mortgage interest or rent, and internet and telephone use. However, in this case, it might be better to use the simplified expenses option, which uses flat rates for these sorts of private-business expenses.

Looking for business advice? Get in touch with Cloudco today

CloudCo, an online accounting specialist, offers a wide range of bookkeeping, accounting, and business services to the UK’s sole traders, small and medium businesses, and limited. From expert business advice to company secretarial services, from business planning to bookkeeping, from corporate tax, VAT, and company formations to calculating and filing sole traders’ Self-Assessment tax returns, our teams of experienced accounting professionals are here to help.

Whether your business profits are modest or mega, CloudCo does not discriminate! We consistently provide the same sound, expert service to all our clients. Contact us today.

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