Are you a newly registered sole trader trying to work out the best way to take money out of your own business?
Being self-employed as a sole trader is very different to being employed by a company or even owning a limited company. It’s essential to understand the difference in business income as a sole trader to make the best use of this unique status and ensure success as a self-employed person.
Many sole traders get a bit confused when it comes to the topics of drawings and wages; it’s all money from your business so does it really matter? In this article, we’ll explain the differences between drawings and wages. We look at which method you should be using as a sole trader to ensure you’re fairly compensated each month for your self-employment and stay on the right side of the line when it comes to your tax obligations and completing an annual self-assessment tax return.
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The Differences Between Wages And Drawings
Most people are familiar with how wages and salaries work; wages are paid weekly and salaries monthly from a company or other employment organisation to an employee.
Wages can only be paid by registered companies and employers. If you own a company of your own, you can register as an employer and pay yourself a wage. Wages are viewed as an allowable business expense and are tax-deductible. All wages need to be calculated and recorded through the PAYE (Pay as You Earn) system.
Sole traders can’t receive a salary, so they pay themselves through personal drawings from the business. Drawings are money taken from business profits and can be taken at any time providing the business has enough cash flow.
As A Sole Trader, Can I Pay Myself A Wage?
You can’t pay yourself a wage as a sole trader. Only a limited company can pay wages and salaries to their employees. If you want to extract money from your business regularly like a wage or salary, you must do this by taking drawings.
As a sole trader, there is no legal distinction between you and your business, so the money (drawings) you take cannot be classified as a salary or wages.
How Should I Structure My Drawings?
Drawings can be made by sole traders from their business accounts and are seen as the sole trader’s personal income. Drawings can be made at any time and may not be regular like a salary or wages which tend to be on scheduled dates.
One of the biggest differences between drawings and wages or salary is that drawings are not an allowable expense when calculating business profit and consequently, are not tax-deductible. Sole traders must keep track of their business income and expenses and pay tax on the profits at the end of the financial year.
It’s important to structure your drawings in a sensible way. As a sole trader, your finances and your business finances are basically linked. However, it’s advisable to keep personal and business finances separate to avoid confusion.
It’s best practice to have a separate bank account for drawings, possibly a business account. This way you’ll be able to keep your money separate; it will help you maintain accurate records, and you’ll be able to gain a clear understanding of your business finances as well as your profits.
If you are someone who needs a bit more structure and stability when it comes to your finances, you may want to pay yourself a set amount each week or month – essentially meaning your drawings act as regular income.
Find an amount that will remain under your profit margin and pay it to yourself regularly, so you have a steady and consistent flow of money. This will help you to keep track of your expenditure and help you budget and balance your finances, as well as save towards bigger expenses such as a new car or a holiday.
Setting Up A Drawings Account
If you want to manage your cash flow better without relying on the same current account that you have for personal use, then a separate business account just for drawings is a great idea for many sole traders. It’s easy to demonstrate to HMRC the money you use as personal drawings each month (essentially acting as your salary), as the account provides a clear record. It will help you to track income and other finances such as money you use to pay businesses for goods and services you need to operate as a sole trader and keep them separate from your personal costs.
If your sole trader finances are becoming more complex to manage, you could pass the responsibility of recording your personal drawings and business expenses to a registered accountant instead, giving you the time to focus on your business. This isn’t, of course, for everyone, but may work for some if you want to focus on the business side of your sole trader setup, rather than managing the finances.
Tax and National Insurance Contributions As A Sole Trader
A sole trader pays tax on the business profit as part of their personal income, using individual income tax rates and including allowable deductions. As a sole trader, your business is not a separate legal entity so your business profits are added to any other personal income you may have such as pension payments, wages, or investment interest. This aggregated figure is your total taxable income.
Business profits are calculated by taking total business income and deducting allowable business expenses.
You are personally liable for all your tax bills, so it is very important that you keep detailed records of all of your drawings as they are seen as profits.
Before the 31st of January each year, you’ll need to submit a self-assessment tax return which will generate a tax liability based on your profits. There are certain thresholds below which you won’t be taxed, but you’ll still need to submit a self-assessment to demonstrate that you fall below this level. General UK government guidance is that if you earn over £1,000, then it should be declared in a self-assessment form, even if you don’t reach the threshold for tax.
You should allocate money to cover your personal tax bill by retaining sufficient funds to cover the tax liability generated on your profits. Most experts recommend saving around 25% of your drawings for future tax bills. This should more than cover any tax bill you are given at the end of the tax year, and potentially leave a little left over in savings, too.
National Insurance Contributions
National Insurance contributions are another thing that you’ll have to consider. NI contributions are only applicable once you start earning over a certain threshold. For the current tax year, the thresholds for National Insurance contributions for sole traders are as follows:
- NIC Class 2 Contributions: £3.50 per week for profits above £12,570 a year
- NIC Class 4 Contributions: 6% on profits between £12,570 and £50,270 and 2% on profits above £50,270
National insurance contributions are vital to build your entitlement to certain benefits and the State Pension. HMRC will also send a bill for these, so money needs to be set aside to pay for income tax and national insurance contributions.
What Are Allowable Business Expenses For Sole Traders?
Allowable business deductions include the following:
- Business travel – This includes things like vehicle insurance, fuel, and transport expenses.
- Legal expenses – Lawyers expenses, business insurance, and accounting
- Marketing – The cost of advertising and PR
- Office expenses – Items like stationery, postage, and film bills
- Clothing and uniforms including protective clothing
- Business premises – Rent, upkeep, utility, internet, bills, and security
- Home office expenses
- Depreciation of equipment used in the course of your business>
- Training courses – Any training undertaken in order to improve your skillset
Keep detailed records of all your business expenses so that you can claim back for anything that is an allowable expense when you complete your tax return.
Other Things You Should Know As A Sole Trader
- You need to register with HMRC – Whether you’re earning above the tax threshold or under it, you will still need to register with HMRC when you begin your journey as a self-employed individual. You’re officially seen as self-employed when you earn £1,000 or more from a particular task. You can register with HMRC before you reach this threshold on a voluntary basis.
- Registering is easy – If you are put off from registering because you think it’s going to be a time-consuming process, don’t worry, as the whole thing can be done within a couple of hours, and the UK government website has plenty of resources to help those who are struggling.
- There is a fair amount of risk involved when becoming a sole trader – This is because your business finances and personal finances are mixed, and you will be fully liable for expenses whether your business succeeds or fails unlike the corporate veil that exists with a limited company. It’s a step that requires careful thought and financial organisation.
- You may have to register for VAT – If your taxable turnover exceeds £90,000 within any rolling 12-month period, then you will have to register for VAT. This raises a requirement to continuously monitor your sales to check where you are in relation to this threshold as the twelve months is not a fixed calendar year.
If you’re at all concerned about how you should handle your business finances as a sole trader, get in touch with a registered financial advisor or accountant to get the right advice and guidance to reflect your specific situation. Professional support can be intensive or light touch depending on how your business develops over time and your own understanding of how you need to handle your finances.
