It’s not often I see fear in a client’s eyes. This happened recently, though, when I casually mentioned National Insurance. The chap concerned had just gone freelance, after carefully planning his transition from employee to free spirit. Somehow, in all the excitement, a crucial element had escaped his notice. Understandably so, I think. After all, nobody who creates a business has a burning desire to understand the National Insurance (NI) system. However, a basic knowledge of how NI works, and what you need to pay and when, will help you now and when you reach state retirement age.
In this post, I’ll explain this unnecessarily complicated tax and also share some tips on paying it if you’re self-employed.
What is National Insurance?
When it was first introduced in 1911, National Insurance was indeed an insurance scheme. Contributors were rewarded with payouts if unable to work or once they’d reached the state retirement age (70, at the time). The method of recording contributions was through stamps affixed to a card, which is why you’ll sometimes hear people refer to paying your stamp.
It’s since become far more sophisticated and there are now six types of National Insurance contribution. Thankfully, as a sole trader, you need only concern yourself with two of them:
Class 2 National Insurance
This is a fixed weekly amount of £3, regardless of your income. You’re not obliged to make Class 2 contributions unless your profits1 exceed £6,365. Nevertheless, it could be worth making voluntary Class 2 contributions. Why on earth would you pay more tax than necessary? Well, because this affects your state pension entitlement. To qualify for the full state pension, you need to have made 35 years’ NI contributions. Any gaps reduce the amount you’ll receive. So, paying £156 per year now could boost your income significantly in the future. Additionally, you need to have made Class 2 contributions to be eligible for other benefits, such as Employment and Support Allowance (the only sick pay you’re entitled to as a sole trader).
Class 4 National Insurance
These contributions behave more like a tax. Class 4 contributions are paid as a portion of your profits, so what’s left over once you’ve deducted any allowable expenses from your turnover. You’re liable for Class 4 NI payments if your profits exceed £8,632. You’ll pay 9% on profits from £8,632-£50,000, and 2% on profits above that amount. These contributions aren’t linked with state benefits.
- Class 2 if your profits are £6,365 or more a year and
- Class 4 if your profits are £8,632 or more a year
- You pay £3 per week (£156 per year) for Class 2 and
- 9% on profits from £8,632 – £50,000 for Class 4. It drops to 2% on profits above £50,000.
How do I pay National Insurance?
Fortunately, this part is straightforward – and you no longer have to collect stamps on a card. Both Class 2 and Class 4 contributions are paid along with income tax through your self-assessment tax return. As you probably know, this is due by 31st January – both the return itself, and your payment.
You stop paying any NI contributions once you reach state retirement age, although you’re still liable for income tax.
How can I calculate my National Insurance liability?
The best way to deal with tax returns is to prepare well in advance. The tax year ends on 5th April, so you have almost 10 months to do some calculations and start saving, if you haven’t already put some money aside. StepChange has created a useful online calculator to give you clarity on what you’ll need to pay. For example, if your turnover is £30,000 and your business costs are £2,000, you’d pay:
- Class 2 – £156
- Class 4 – £1743.12
- Income tax – £3099.96
That’s a total of £4999.08.
As a sole trader, your income probably fluctuates. It’s worth using this calculator each month to ensure that you’re not taking too much money out of the business. Nobody enjoys saving for tax, but a monthly sacrifice is better than a big bill just after Christmas. Remember, Class 2 contributions are fixed at £3 per week, so it’s easy-peasy to budget for this amount. Think of it as an annual subscription of £156 that you pay every January.
The Government has promised to overhaul National Insurance and a review is currently in progress. Given everything else that’s going on, this is unlikely to be a priority. In the meantime, using the calculator and setting aside your £156 should keep you on track. And you might even get a state pension when you’re 95.
- turnover minus allowable expenses [↩]