Explain It Like I'm 5: Tax Relief

gasworries

Hi,

I'm about to go freelance as a graphic designer (as a sole trader), and I'm wondering exactly how tax relief works.

Am I correct in saying that, say I earn, for arguments sake, £100,000 over the year (I wish!). I would save 20% of those earnings for when it comes to paying tax - so £20,000.

Now if I wish to buy a computer, and the computer is £1000, then would I theoretically be paying a tax bill of £19,000? So do you get the full amount off your tax bill, or just a percentage of it?

And if I were to buy something second-hand, would I be able to claim that if I don't have a "proper" receipt?

Apologies for my stupidity!

CLAPTON

you are liable for tax and National Insurance on the PROFITS you make.

The profits are the difference between your income and your allowable costs/expenses

should you earn a lot then tax works as follows

for this year 2012-13

the first 8100 is tax free
the next 34370 is taxed at 20%
over that amount is taxed at 40%
over 150,000.. well by then you will have an accountant

you also pay NI class 2 and class 4 contributions

class 2 is 2.65 per week
and class 4 is 9% on profits between 7854 and 42,475 then it's 2%

Pennywise

gasworries wrote: »

Now if I wish to buy a computer, and the computer is £1000, then would I theoretically be paying a tax bill of £19,000? So do you get the full amount off your tax bill, or just a percentage of it?

No, your £100k income would be reduced by the £1k you spent leaving £99k taxable.

I hope you realise that 20% tax is far too low. Even for much lower profits, it would be around 29% (tax 20 and NIC 9).

Assuming no other income, combined tax and NIC is as follows (rough for illustration only).

First £8k tax free.
Next £34k, 29%
Above £42k, 42%

All plus class 2 NIC which is around £3 per week regardless of profits (as long as over £6k ish).

Then above £100k, you start to lose your personal allowance.
Above £150k you're into the higher, higher rate, meaning tax/nic of 47% on the excess.

So, if your profits are £100k, by spending £1k on a computer, you save £420 in tax, meaning it costs you £580 after tax relief.

gasworries

Thanks for that chaps.

And is that the same rule if I were to register as a ltd company?

CLAPTON

gasworries wrote: »

Thanks for that chaps.

And is that the same rule if I were to register as a ltd company?

best walk before you learn to run
time to start a ltd company once you have made some money and can afford an accountant

gasworries

CLAPTON wrote: »

best walk before you learn to run
time to start a ltd company once you have made some money and can afford an accountant

Thanks.

I charge £250 a day and I'm already quite booked up, so I'm expecting to earn in excess of £42k, so I just thought it could be worth speaking to an accountant about this option.

agrinnall

If you do earn £42k (and certainly if you earn £100K) then a limited company probably will enable you to cut your tax bill. But there are cost, time and administrative burden overheads to running one, and I'd agree with clapton that you are better to see if you really do make as much as you hope before going down that route.

notanewuser

Not to mention that once turnover hits £77k you must register for VAT.

couponosaurus

Starting a limited company will help you cut your tax if you earn over ~50 thousand and freelancing can be quite risky as you're not always sure of work, right? Maybe do it after 1 year of doing it and see what you get?

somethingcorporate

It doesn't take many void days at £250pd to bring your income back down to less than £42k. With expenses I would positively expect you to earn lower than this threshold. You could always consider payments into a pension to lower your taxable income too.

Owain_Moneysaver

gasworries wrote: »

Am I correct in saying that, say I earn, for arguments sake, £100,000 over the year (I wish!). I would save 20% of those earnings for when it comes to paying tax - so £20,000.

Now if I wish to buy a computer, and the computer is £1000, then would I theoretically be paying a tax bill of £19,000? So do you get the full amount off your tax bill, or just a percentage of it?

No. It's not that simple. You pay tax on your net profit, which is income less expenses.

Although you've spent £1000 on the computer you've purchased an asset, so you haven't lost £1000.

HMRC have detailed rules about what you can set against tax regarding depreciation of assets. Very simply, if HMRC say the allowed depreciation for your computer is 20% per year:

End of Year 1:

Profit and Loss Account

Income £100,000
Other expenses £20,000
Depreciation (20% of £1,000) £200
Total expenses £20,200
Net profit £79,800 You will pay tax on £79,800 less your personal allowances.

Balance Sheet

Assets

Computer (£1,000 less depreciation £200) £800

End of Year 2:

Profit and Loss Account

Income £100,000
Other expenses £20,000
Depreciation (20% of £800) £160
Total expenses £20,160
Net profit £79,840 You will pay tax on £79,840 less your personal allowances.

Balance Sheet

Assets

Computer (£1,000 less depreciation £200+£160) £640

You also have to account for expenses which you pay for which cover across your financial year end. This is called accrual. For example, on 1 Jan you pay your annual insurance premium of £120. Your financial year ends on 31 March.

Your expenses which you can claim against tax this year would be £30 for three months' insurance, and you would claim the remainder of the premium against next year's tax.