How Income Tax Works for Sole Traders
Income tax is payable on profits made from self-employment after allowable business expenses have been deducted. For sole traders and most self-employed individuals, the income tax system operates under a progressive structure. This means different portions of your income are taxed at different rates, depending on how much you earn.
Each individual is entitled to a tax-free personal allowance. Income above that allowance is then taxed based on which income band it falls into. These bands have remained consistent in structure over recent years, but the thresholds and limits have been subject to change.
The Personal Allowance: What It Means
The personal allowance is the amount of income you can earn each tax year without being liable for income tax. This allowance is applied to your total income, which includes earnings from self-employment, employment, rental income, and dividends, among other sources. Once your total income exceeds the personal allowance, the rest is taxed according to the band it falls within.
In recent years, the personal allowance has remained at £12,570. However, higher earners may see their allowance reduced. This reduction begins when total income reaches £100,000 and is completely removed once it hits a set limit, which has also shifted slightly over time.
Income Tax Bands for the 2024/25 Tax Year
For the current tax year, the following tax bands apply to self-employed individuals in England and Northern Ireland:
- Income up to £12,570 is tax-free under the personal allowance
- Income from £12,571 to £50,270 is taxed at the basic rate of 20 percent
- Income from £50,271 to £125,140 is taxed at the higher rate of 40 percent
- Income over £125,140 is taxed at the additional rate of 45 percent
The income limit for the personal allowance is set at £125,140. For those earning above this threshold, the allowance is reduced to zero.
Income Tax Bands for the 2023/24 Tax Year
The structure for the 2023/24 tax year mirrors that of 2024/25. The thresholds and rates remain unchanged:
- Personal allowance applies to income up to £12,570
- Basic rate applies between £12,571 and £50,270
- Higher rate applies from £50,271 to £125,140
- Additional rate is charged on income above £125,140
The consistency across these two tax years offers some predictability for taxpayers and helps with forward planning.
Income Tax Bands for the 2022/23 Tax Year
In 2022/23, the bands and rates were similar to the subsequent two years, except for a higher threshold for the additional rate. Here’s the breakdown:
- Personal allowance: Up to £12,570
- Basic rate: £12,571 to £50,270 at 20 percent
- Higher rate: £50,271 to £150,000 at 40 percent
- Additional rate: Over £150,000 at 45 percent
The income limit for the personal allowance was £100,000. This meant that for every £2 earned above this amount, the allowance was reduced by £1, reaching zero once income hit £125,000.
Tax Bands and Allowance Limits for 2021/22
The personal allowance remained at £12,570 in the 2021/22 tax year. The income tax structure was:
- Income up to £12,570: No tax
- Income from £12,571 to £50,270: Basic rate at 20 percent
- Income from £50,271 to £150,000: Higher rate at 40 percent
- Income over £150,000: Additional rate at 45 percent
The personal allowance started reducing once income surpassed £100,000 and was fully withdrawn by £125,000.
Income Tax Bands for 2020/21
In the 2020/21 tax year, the personal allowance was slightly lower than in later years, set at £12,500. The income tax bands were structured as follows:
- Income up to £12,500: Tax-free under personal allowance
- Income from £12,501 to £50,000: Basic rate of 20 percent
- Income from £50,001 to £150,000: Higher rate of 40 percent
- Income above £150,000: Additional rate of 45 percent
The income limit for personal allowance remained £100,000. Once this threshold was crossed, the allowance began tapering.
Income Tax Bands for 2019/20
The 2019/20 tax year continued with the same personal allowance of £12,500, but the thresholds for the basic rate were different:
- Personal allowance: Up to £12,500
- Basic rate: £12,501 to £37,500 at 20 percent
- Higher rate: £37,501 to £150,000 at 40 percent
- Additional rate: Over £150,000 at 45 percent
The tapering of the personal allowance also started at £100,000, as in previous years.
Income Tax Bands for 2018/19
In 2018/19, the personal allowance was slightly lower, set at £11,850. Income tax bands for that year were:
- Up to £11,850: No tax
- £11,851 to £34,500: Basic rate at 20 percent
- £34,501 to £150,000: Higher rate at 40 percent
- Above £150,000: Additional rate at 45 percent
The personal allowance reduction began once total income crossed the £100,000 mark.
Income Tax Bands for 2017/18
The earliest tax year covered in this overview is 2017/18, when the personal allowance stood at £11,500. Income was taxed as follows:
- Up to £11,500: 0 percent
- £11,501 to £45,000: 20 percent
- £45,001 to £150,000: 40 percent
- Over £150,000: 45 percent
The income threshold at which the personal allowance was fully removed remained at £100,000, as was standard during this period.
Observations on Historical Trends
Looking back across these tax years, a few trends become evident. Firstly, the personal allowance has generally increased over time, rising from £11,500 in 2017/18 to £12,570 by 2021/22, where it has remained. This increment is part of efforts to ease the tax burden on lower earners.
Secondly, while the basic and higher rate percentages have not changed significantly, the income thresholds for these bands have varied, affecting how much income is taxed at each rate. For example, in 2017/18, the higher rate started at £45,001, while in 2024/25 it now begins at £50,271.
Another noticeable shift occurred in 2023/24 and 2024/25 when the threshold for the additional rate was lowered from £150,000 to £125,140. This change means that more high earners now fall within the additional rate bracket, increasing their overall tax liabilities.
Finally, the tapering of the personal allowance has consistently started at £100,000 in all years except 2023/24 and 2024/25, when it was tied directly to the new additional rate threshold of £125,140. The interplay between the personal allowance and these bands means that individuals earning above the tapering point can end up paying higher effective rates on portions of their income.
Regional Variations in Taxation
While these tax bands apply to England and Northern Ireland, it’s important to recognize that tax structures differ in Scotland and Wales. Scotland, in particular, has introduced additional tax bands and applies slightly different rates. Therefore, if you’re self-employed and based in Scotland or Wales, you’ll need to consult the relevant government guidelines for accurate figures.
Understanding Class 2 and Class 4 NICs and Their Impact from 2018 to 2025
National Insurance is a vital aspect of the UK tax system and directly affects the self-employed, including sole traders and freelancers. These contributions fund key public services and state benefits such as the State Pension, Maternity Allowance, and certain welfare programs. Understanding how National Insurance Contributions (NICs) work can help self-employed individuals stay compliant, maintain benefit entitlements, and avoid unexpected liabilities.
Unlike employees, who have contributions deducted through PAYE by their employers, self-employed people are responsible for calculating and paying their NICs through the Self Assessment process. Two types of National Insurance contributions apply to self-employed individuals: Class 2 and Class 4. The obligation to pay either depends on the amount of annual profit earned.
Role of National Insurance for the Self-Employed
NICs play a key role in determining eligibility for various benefits, including the State Pension. Regular contributions build up entitlement to benefits, even if the contributions themselves seem relatively small compared to income tax. Because of this, many self-employed individuals opt to pay Class 2 NICs voluntarily if their profits fall below the compulsory threshold.
Unlike employees, who pay Class 1 contributions, the self-employed deal with a different system. Class 2 and Class 4 are the main categories relevant for those running their own businesses or freelancing.
What Are Class 2 NICs?
Class 2 NICs are flat-rate weekly payments for self-employed individuals whose annual profits exceed the Small Profits Threshold. These contributions give access to certain state benefits, including the basic State Pension, Maternity Allowance, and Employment and Support Allowance under specific conditions.
If annual profits are above the threshold, payment of Class 2 NICs is required unless the individual qualifies for certain exemptions. If profits fall below the threshold, individuals can choose to pay voluntarily to maintain their National Insurance record.
Key Changes from April 2024
As of the 2024/25 tax year, major reforms have been introduced to simplify the National Insurance system for self-employed individuals. These changes are especially relevant for those earning more than the lower profits limit.
- Self-employed individuals with profits above £12,570 are no longer required to pay Class 2 NICs.
- Those earning between £6,725 and £12,570 will continue to receive National Insurance credits, maintaining their eligibility for contributory benefits, without the need to pay Class 2 NICs.
- Individuals earning below £6,725 can continue to make voluntary payments at the rate of £3.45 per week to maintain access to the State Pension and other benefits.
This change represents a shift toward streamlining the system while preserving access to essential benefits for those with lower profits or variable income. The abolition of compulsory Class 2 NICs above £12,570 reduces administrative work for many freelancers and sole traders.
Why Voluntary Payments Still Matter
Even though those with lower profits are not obliged to pay Class 2 NICs, doing so voluntarily can protect long-term entitlements. In particular, maintaining a full National Insurance record is essential for receiving the full State Pension in the future. It’s generally considered good practice for those with modest earnings to continue contributing if they can afford it.
Voluntary contributions can be made via the Self Assessment system and are usually due alongside annual income tax and other NIC liabilities. The option remains especially useful for part-time freelancers, students, or those just starting a business who want to ensure continuous contribution records.
What Are Class 4 NICs?
Class 4 NICs are calculated as a percentage of self-employed profits. These contributions are only payable when profits exceed the Lower Profits Limit. Unlike Class 2 NICs, Class 4 contributions do not count towards State Pension entitlement but still form part of your total tax liability.
The percentage rates applied vary depending on the level of income. There are two distinct rates:
- A main rate applied to profits between the Lower and Upper Profits Limit
- A reduced rate applied to profits above the Upper Profits Limit
Significant Adjustments in 2024/25
The 2024/25 tax year introduced a key rate cut in Class 4 NICs. The main rate dropped from 9 percent to 6 percent, offering some tax relief to self-employed individuals. This adjustment reduces the overall contribution burden, particularly for middle-income earners whose profits fall within the standard range.
This change, combined with the elimination of Class 2 NICs for higher earners, reflects efforts to simplify the self-employment tax system and reduce the administrative load for small business operators.
Comparing Class 2 and Class 4: What’s the Difference?
While both Class 2 and Class 4 NICs apply to self-employed individuals, they serve different purposes:
- Class 2 is a flat weekly rate that counts toward benefit entitlements, including the State Pension.
- Class 4 is a profit-based contribution that does not provide direct access to benefits.
Together, they represent the self-employed equivalent of employee National Insurance. While Class 4 is mandatory if you exceed the threshold, Class 2 is now only mandatory for some and voluntary for others. Understanding when and how to pay each class ensures you avoid underpayment while maintaining benefit eligibility.
How to Pay National Insurance as a Self-Employed Person
NICs for the self-employed are paid through the Self Assessment system. When you submit your annual tax return, your total profits are used to calculate your NIC liability. HMRC automatically works out how much Class 2 and Class 4 NICs you owe and includes them in your overall tax bill.
Payments are generally due in two installments:
- The first on 31 January (covering the previous tax year)
- The second on 31 July
You can pay online, by direct debit, or via bank transfer. Late payments may incur penalties and interest charges, so it’s important to keep track of deadlines.
What You Should Consider
Managing your National Insurance responsibilities is an important part of running a successful business. By understanding the thresholds, rates, and voluntary options, you can make informed choices that align with your financial and long-term personal goals. Here are a few key points to consider:
- Estimate your expected annual profit early in the tax year to anticipate whether you’ll owe Class 2 or Class 4 NICs
- If you’re earning below the threshold for Class 2, think about making voluntary contributions to protect your State Pension
- Set aside funds throughout the year to cover NICs along with income tax to avoid large, unexpected payments
- Check your National Insurance record annually to ensure your contributions are being properly logged and credited
Understanding Dividend Tax, Allowances, and Historical Changes from 2017 to 2025
For self-employed individuals who operate through a limited company, dividend income often plays a central role in how they pay themselves. Choosing to extract profits from a business via dividends can offer a more tax-efficient approach than drawing a salary alone. However, dividends are subject to tax beyond certain thresholds, and these rules have changed considerably in recent years.
This section explores how dividends are taxed, how allowances have evolved, and what rates apply depending on your income band. Whether you are already drawing dividends or are considering incorporating your business to begin doing so, a strong understanding of these rules will help you stay compliant and tax efficient.
What Are Dividends?
Dividends are payments made by a company to its shareholders from post-tax profits. They represent a portion of the business’s earnings that are distributed rather than retained for reinvestment. In the context of small businesses, many self-employed individuals choose to establish a limited company and then pay themselves a combination of salary and dividends to reduce their tax burden.
A director or shareholder receiving dividends benefits from the fact that these payments are not subject to National Insurance contributions. This distinguishes them from employment income, where both employees and employers must contribute. However, dividend income is not entirely tax-free. Depending on how much you receive, it may be taxed at a specific rate based on your total taxable income and tax band.
How Dividend Income Is Taxed
Dividend tax is assessed on the portion of dividend income that exceeds the annual dividend allowance. You only pay tax on the amount above the allowance, and this tax is charged at a separate set of rates distinct from income tax on earnings or profits.
Importantly, dividend income that falls within your personal allowance is tax-free. The dividend allowance is an additional tax-free threshold on top of the personal allowance, making it possible to receive some income through dividends without paying any tax.
The dividend tax you pay depends on which income tax band you fall into once total income (salary, dividends, business profits, and other income sources) is taken into account.
Dividend Allowance by Tax Year
The dividend allowance has seen a series of reductions in recent years, significantly affecting self-employed individuals who operate through limited companies. In the 2017/18 tax year, the allowance was set at £5,000, enabling many small business owners to receive a considerable portion of their income in dividends without incurring tax. However, this threshold was reduced to £2,000 in 2018/19, where it remained steady through to the 2022/23 tax year.
In 2023/24, the allowance was halved to £1,000, and from April 2024, it was cut further to just £500. These successive reductions mean that more of an individual’s dividend income is now subject to tax, even if their overall income has not increased. As a result, company directors and small business owners who pay themselves via dividends are likely to experience higher tax liabilities unless they adjust their financial strategies accordingly.
Dividend Tax Rates Based on Income Band
The amount of tax paid on dividends above the allowance depends on the individual’s income tax band. These rates are different from standard income tax rates and are designed to reflect the fact that company profits are already taxed at the corporate level before dividends are distributed.
Tax Rates for 2024/25, 2023/24, and 2022/23
For these tax years, the following dividend tax rates apply:
- Basic rate taxpayers: 8.75 percent
- Higher rate taxpayers: 33.75 percent
- Additional rate taxpayers: 39.35 percent
These rates apply to dividend income that exceeds the allowance and falls within the respective income tax bands. For example, if your total taxable income, including dividends, places you in the basic rate band, any dividend amount above the allowance is taxed at 8.75 percent.
Tax Rates for 2021/22
In the 2021/22 tax year, dividend tax rates were slightly lower:
- Basic rate: 7.5 percent
- Higher rate: 32.5 percent
- Additional rate: 38.1 percent
These rates had been in place since the introduction of the dividend allowance in 2016. The increases from April 2022 onwards were part of a broader plan to raise revenue for health and social care funding in the UK.
Practical Example: How Dividend Tax Is Calculated
To better understand how these rates apply in practice, let’s consider a simplified example for the 2024/25 tax year.
Suppose you are the sole director of your limited company and you take a salary of £9,000 and dividends of £35,000. Your total income would be £44,000.
- Your salary falls below the personal allowance, so you still have £3,570 of personal allowance remaining
- £3,570 of the dividend income is tax-free under the remainder of your personal allowance
- The next £500 of dividend income is tax-free under the dividend allowance
- This leaves £30,930 of taxable dividends
- Since your total income is still within the basic rate band, this £30,930 is taxed at 8.75 percent
The dividend tax liability in this case would be £2,707.88. This approach demonstrates how even modest dividend payments can now trigger significant tax liabilities, especially with the allowance reduced to £500.
Why the Dividend Tax Changes Matter
The reduction in the dividend allowance over recent years has important implications for small business owners. Previously, many were able to structure their income to pay little to no tax on dividends. With the allowance now limited to just £500, virtually all dividend income will attract some level of taxation unless overall income is minimal.
These changes also shift the balance in decisions about whether to incorporate a business. In the past, incorporating and drawing dividends was almost always more tax-efficient. Now, for some individuals, the benefit may be marginal depending on how much income is withdrawn from the company. It is increasingly important to conduct thorough year-end tax planning and consider how dividends interact with other income sources and thresholds.
Interaction with Other Allowances and Thresholds
When calculating your tax liability, the order in which allowances and tax bands are used matters. The personal allowance is applied first, reducing taxable income from all sources. The dividend allowance is applied afterward, but only to dividend income specifically.
For example, if you have employment income of £10,000 and dividend income of £20,000, the personal allowance covers all of your employment income and part of your dividend income. Then, the dividend allowance is applied to what remains, followed by dividend tax rates on any residual dividend income.
Additionally, income from dividends can affect other entitlements. For example, if your total income crosses the £100,000 mark, your personal allowance will begin to taper off. Similarly, higher income levels may affect your eligibility for child benefit or personal savings allowances.
Planning Strategies for Managing Dividend Tax
There are several ways that self-employed individuals and small company directors can manage their dividend tax liability:
Timing Dividends Across Tax Years
Delaying a dividend until after the new tax year may help keep income within a lower tax band. This strategy requires careful forecasting and accounting, particularly if the dividend will push you into a higher bracket.
Using Spouse or Partner Allowances
If a spouse or partner has unused personal or dividend allowances, consider transferring shares and splitting dividend income. This is a legitimate tax planning approach that takes advantage of both individuals’ allowances and lower tax bands.
Keeping Dividends Within the Basic Rate
Some business owners aim to keep dividend payments within the basic rate tax band to benefit from the lower 8.75 percent rate. This requires aligning other income sources and managing withdrawals from the company accordingly.
Consider Pension Contributions
Making pension contributions can reduce taxable income and help preserve personal and dividend allowances. This approach offers long-term retirement benefits while improving tax efficiency.
Retaining Profits in the Company
If dividend withdrawals are likely to trigger high tax charges, it may be more advantageous to leave profits in the business and take them out in future years when tax rates or personal income levels may be lower.
How Dividends Fit into a Broader Tax Plan
The decision to take income as dividends is just one part of a broader financial strategy. It should be weighed alongside salary payments, pension contributions, business expenses, and personal financial goals.
Using an integrated approach that considers how different income types affect tax liabilities can help business owners preserve more of their earnings while maintaining compliance.
Tax efficiency should not come at the expense of long-term security or benefit entitlements. Ensuring National Insurance contributions are adequate and that personal allowances are fully utilized is just as important as minimizing dividend tax exposure.
Conclusion
Understanding how the UK tax system applies to self-employed individuals is essential for anyone running a business as a sole trader or through a limited company. Whether you’re new to self-employment or an experienced freelancer, the complexities of income tax, National Insurance contributions, and dividend taxation require careful attention throughout the financial year.
We explored the structure of income tax bands and how your earnings above the personal allowance are taxed based on thresholds that have evolved over time. These tax bands—basic, higher, and additional—impact how much tax you owe and highlight the importance of proper income planning.
We focused on National Insurance contributions, explaining the roles of Class 2 and Class 4 NICs for self-employed individuals. The recent abolition of Class 2 NICs for those earning above the lower threshold and the reduction in Class 4 rates show the government’s effort to simplify the system. Despite these changes, maintaining contributions—especially voluntarily for those on lower earnings—remains critical for accessing benefits like the State Pension.
We examined how dividends are taxed, the shrinking dividend allowance, and what tax rates apply depending on your income band. The reduction in the allowance from £5,000 to just £500 over the past several years has significantly increased the tax liability for limited company owners. Proper dividend planning is now more important than ever to ensure income is withdrawn tax-efficiently and without unintended financial consequences.
Together, these three areas form the foundation of self-employment taxation in the UK. By staying informed about rate changes, thresholds, and allowances each tax year, self-employed individuals can make proactive decisions to optimize their financial outcomes. Keeping accurate records, submitting timely returns, and planning for future tax obligations are not only best practices—they’re necessary to sustain a healthy, compliant, and financially efficient business.
Whether you choose to operate as a sole trader or run a limited company, your awareness and understanding of these systems will help you retain more of your income, stay eligible for key benefits, and remain focused on what matters most: growing and managing your business successfully.