How Much Should You Set Aside for Tax as a Sole Trader?

For many sole traders, tax is not the problem — cash flow is.  This is because the majority of tax issues faced by self-employed people in the UK do not arise because they are paying too much tax (although it is to some extent getting that way in recent years!), but because they have not set aside enough money to pay the tax they already owe.

Unlike employees, sole traders do not have tax deducted at source. There is no employer calculating PAYE, no automatic deduction for National Insurance, and no reminder each month that part of your income is not really yours. Instead, tax builds up quietly in the background until a large bill arrives —the tax year AFTER the income was earned.

This article therefore explains why it is essential for sole traders to set aside sufficient funds for tax, and how you can estimate a “safe” amount to put aside during the year. It is written for UK sole traders and focuses on Income Tax, National Insurance, Payments on Account, and the upcoming changes under Making Tax Digital.

 

What Rates of Income Tax Do Sole Traders Pay in England, Northern Ireland, and Scotland?

Sole traders pay income tax on their profits, not on their turnover.  This is an important concept and will be discussed in more detail below.  Furthermore, the rates depend on where you live.

 

England, Wales, and Northern Ireland

For Sole Traders in England and Northern Ireland, income tax rates are:

• Personal Allowance: 0% on profits up to £12,570
• Basic Rate: 20% on profits from £12,571 to £50,270
• Higher Rate: 40% on profits from £50,271 to £125,140
• Additional Rate: 45% above £125,140

Although please note that once profits exceed £100,000, the personal allowance is gradually withdrawn, creating an effective marginal rate of 60% tax.

 

Scotland

Scotland has different income tax bands for non-savings, non-dividend income, which includes sole trader profits. There are more bands and slightly higher rates at lower income levels compared with the rest of the UK:

• Personal Allowance: 0% on profits up to £12,570
• Staring Rate: 19% on profits between £12,571 to £15,397
• Basic Rate: 20% on profits from £15,398 to £27,491
• Intermediate Rate: 21% on profits from £27,492 to £43,662
• Higher Rate: 42% on profits from £43,663 to £75,000
• Advanced Rate: 45% on profits from £75,001 to £125,140
• Top Rate: 48% on profits above £125,140

The key takeaway is this: Scottish sole traders generally start paying higher marginal tax rates earlier, which increases the importance of conservative tax saving.

 

Why Profits — Not Turnover — Are More Important for Sole Traders?

One of the most common mistakes new sole traders make is thinking about tax in terms of turnover rather than profit.

 

Turnover vs Profit

Turnover is the total amount you invoice or receive from customers.

Profit is what remains after deducting allowable business expenses, which for Sole Traders includes any expenditure which is “wholly and exclusively” for business purposes.

For Sole Traders tax is calculated on profit, NOT turnover.

For example:

Turnover: £80,000

Expenses: £40,000

Profit: £40,000

You will therefore pay tax on £40,000 and not £80,000.

This matters enormously when deciding how much money to set aside, because two Sole Traders with the same turnover can have very different tax bills depending on their costs, and resultant profitabilities!

 

How to Estimate Profits Earlier in the Year

Unfortunately, you wont know for sure what your profitability will be until the tax year is over and you have prepared your accounts.  But waiting until the end of the tax year is risky, because it may be too late to build money to act as a tax reserve.  Therefore, it is essential to regularly estimate what your profit will be as the year progresses so that you can set aside money for taxes, when you still have the cash to do so (e.g. each time you are paid by customers).

Per above, profitability can very significantly from one business to another.  However, techniques you can potentially use include:

• Use last year as a baseline – If your business trade is relatively stable from one tax year to another, then last year’s profit margin ((Profit / Turnover) x 100), can be the best guide.
• Ensure that your accounts are always up to date – As this will allow you to track monthly profit levels instead of just income.
• Apply a growth rate – If your business is growing, make sure to include a growth percentage increase in your estimates, and vice versa if you anticipate your business will do more poorly this year.

Remember – A rough estimate made early and updated regularly (such as quarterly or monthly) is far more useful and safer than a perfect calculation done after the year end, if it is too late to set aside enough funds to meet your tax liabilities!

 

What Types of and Rates of National Insurance Do Sole Traders Pay?

Historically, Sole traders have paid two different types of National Insurance contributions in addition to income tax:

 

Class 2 National Insurance

Class 2 National Insurance used to be paid as a small fixed amount on a weekly basis.  However, in those rare instances where it is still paid (voluntarily), it is now calculated and collected when you prepare and submit your self-assessment personal tax return.

It is charged at the following rates:

• Where profits are more than £6,845 – You are treated as already having paid Class 2 contributions to protect your National Insurance record, and you do NOT have to pay them.
• Where profits are below £6,845 – You can opt to voluntarily pay £3.50 per week.

While payment is voluntary for those that earn profits less that £6,845, you should always still pay this, because (for a relatively small amount of money) it helps protect your entitlement to:

• State Pension
• Certain contributory benefits

 

Class 4 National Insurance

Similar to income tax, Class 4 NICs are calculated as a percentage of your annual trading profits:

• 0% (No Class 4 NICs payable) – On profits up to £12,570
• 6% – On profits between £12,571 to £50,270
• 2& – On profits above £50,270

For most sole traders, Class 4 is therefore the more significant cost and effectively increases the overall tax rate on profits.

 

When Do Sole Traders Have to Pay Their Taxes?

Sole traders report and pay tax through the Self-Assessment personal tax return system.

Key Dates include:

• 31 January
  • Final tax bill payable for the previous tax year. This is the total calculated tax for the previous tax year, less any payments on account you have already made to date.
  • First payment on account for the current tax year
• 31 July
  • Second payment on account for the current tax year

This arrangement can create a significant cash-flow challenges, especially in the first two years of trade, because you effectively have to pay tax for two years at the same time (the year just passed and the current year)!

 

What Are Payments on Account and How Do These Impact My Taxes in the Current Year?

Payments on account are often one of the biggest reasons sole traders underestimate how much tax they need to set aside.

If your tax bill (excluding PAYE) is over £1,000, you are usually required to:

• Pay 50% of next year’s estimated tax in January
• Pay the remaining 50% in July

This means that in January per above you often pay:

• The full tax bill for the year just ended
• Plus half of the next year’s bill

If you only save enough to cover last year’s tax, you may still fall short once payments on account are added. Any “safe” tax reserve must therefore also allow for this.

 

Will My Sole Trader Business Be Impacted by Making Tax Digital (MTD) for Income Tax?

Making Tax Digital for Income Tax wont change the amount of tax you pay, and it wont change the dates by which you need to make tax payments.  BUT it will definitely change how frequently you need to report to HMRC!

What it means in practice is that you will have to use approved accounting software to ensure that your accounting records are kept up to date throughout the year (instead of waiting until after the end of the tax year), and you will need to make periodic (e.g. quarterly) submissions of these records to HMRC, similar to what businesses already have to do for VAT.

MTD for income tax is being phased in for Sole Trader and private property investors over the next few years.

Although in typical style HMRC have made things far more confusing than it needs to be, and instead of using profitability which as discussed at length above is what Sole Traders use to determine and calculate their taxes.  MTD will be phased in based on something called “Qualifying Income”.  Which in very simple terms is the total income (or Turnover) you receive in a tax year from SELF-EMPLOYMENT and PROPERTY.  So, it is the exact opposite of what sole traders need to do in order to calculate their taxes!

You will need to use MTD if ALL of the following apply:

• You are registered for Self-Assessment
• You receive income from self-employment, or property, or both
• You have “qualifying income” of more than £20,000

And the date by which the rules start to apply to you depends on the value of your “qualifying income” (QI).  For instance:

• If QI > £50,000 – Start applying the rules from 6th April 2026
• If QI > £30,000 – Start applying the rules from 6th April 2027
• If QI > £20,000 – Start applying the rules from 6th April 2028

 

Why You Should Use a Separate Bank Account to Hold Tax Reserves?

While there are no rules which say that you have to do this, one of the most effective habits a Sole Trader can develop is keeping money designated for paying taxes completely separate from other business bank funds.

This is because it helps to:

• Remove the temptation to spend this (tax) money
• Make cash flow management easier and less confusing
• Reduce the stress to find these funds as deadlines approach
• Encourage disciplined saving

It therefore encourages you to treat tax as just another expense — by transferring money into a separate tax reserve bank account, each time you get paid by your customers.

 

Given That Tax Is Paid on Profits, What Percentage of Turnover Should I Set Aside?

This is the question most sole traders actually ask — even though tax is calculated on profit.

The answer depends on:

• Your typical profit margin ((Profit / Turnover) x 100)
• Your total estimated profit
• Whether payments on account apply – As per above you will have to set aside extra for the current year if this is the case.

Below are illustrative scenarios using turnover levels that correspond to key profit thresholds.

 

Scenario 1: Lower Profit Sole Trader

Turnover: £30,000

Expenses: £15,000

Profit: £15,000

Taxes payable:

• Income tax: minimal (mostly covered by personal allowance)
• Class 4 NI: low
• Class 2 NI: small fixed amount

Effective estimated tax cost to set aside:

• 10–15% of Profit
• g. 5% of Turnover (but depends on the profit margins of your business)

 

Scenario 2: Basic-Rate Sole Trader

Turnover: £60,000

Expenses: £30,000

Profit: £30,000

Taxes payable:

• Income tax at 20% on profits above allowance
• Class 4 NI on most profits
• Class 2 NI
• Payments on account, if applicable.

Effective estimated tax cost to set aside:

• 25% of Profit
• g. 12-13% of Turnover (but depends on the profit margins of your business)

 

Scenario 3: Higher-Rate Sole Trader

Turnover: £100,000

Expenses: £50,000

Profit: £50,000

Taxes payable:

• Income tax partly at 40%
• Class 4 NI
• Class 2 NI
• Payments on account

Effective estimated tax cost to set aside:

• 30-35% of Profit
• g. 15-18% of Turnover (but depends on the profit margins of your business)

 

Scenario 4: Very High Profit Sole Trader

Turnover: £150,000

Expenses: £60,000

Profit: £90,000

Taxes payable:

• Significant higher-rate income tax
• Possible personal allowance reduction
• Full NI liabilities
• Payments on account

Effective estimated tax cost to set aside:

• 35-40% of Profit
• g. 20% or more of Turnover (but depends on the profit margins of your business)

 

Final Thoughts

Being a sole trader offers flexibility, independence, and control — but it also means taking responsibility for the future payment of your taxes!

If you do one thing differently after reading this article, make it this: Decide on a percentage that most appropriately applies to your business, and move these funds into a separate tax reserve bank account every time you get paid by your customers!  Because you will forever thank the day you started doing this when the payment deadlines for taxes arrive each year.

Even if you underestimate the amounts of tax which will be payable, you will still be in an infinitely better position than you were before!

 

Can QAccounting Help Me?

Yes, we aim to be the UK’s Premier Online Accountancy and Tax Accountant, and we are here to help you every step of the way, whether you need to understand the rules in greater detail or need advice about next best steps.

Please give us a call (0116 243 7868), email us, or contact us ONLINE to speak to a member of our Accounting team without delay!

 

Author: George Ian Hope BAcc(Hons), MSc(IT), FCCA, CGA, CPA

Managing Director – QAccounting Limited (www.qaccounting.com )

https://www.linkedin.com/in/gihope

Ian is a general practicing member of the Association of Chartered Certified Accountants with fellowship status (FCCA). He is also a member of the Certified General Accountants Association of Canada (CGA), and a member of Chartered Professional Accountants of Canada (CPA).

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