Grant asks: “My question is how can I calculate all these benefits including the applicable tax and national insurance to ultimately work out my requirements from a freelance salary to match the financial position as an employee?”
Q&A 73 – How To Calculate My Equivalent Self Employed Salary – Shownotes
This is the second absolute peach of a question from Grant. You are really testing me here man!!
I have a professional career in the construction industry. I am looking to go self-employed and work as a freelancer. I am a 40% income tax payer with a salary of £40,000, I have 25 days annual leave per year plus bank holidays. I have a company car for which I get taxed benefit in kind (the alternate would be a car allowance of circa £5,000 which would also be taxed), with the company car I also get paid 12 pence per mile for all work related travel including return journeys (my current work place is 40 miles from where i live).
I have a pension scheme whereby I pay in 3% of my salary and the company pays in an equivalent 4%. The only other benefit from my employment is sick pay whereby I will be paid my full salary (less statutory sick pay) for sickness and injury ‘in accordance with established timescales’ for the time I am off work.
My question is how can I calculate all these benefits including the applicable tax and national insurance to ultimately work out my requirements from a freelance salary to match the financial position as an employee?
An add-on question or second question would be the comparisons between a sole trader and limited company from a tax and NI perspective with regard to working as an individual?
Right then. The first thing we need to do is to work out exactly how much you currently earn in cash and benefits per hour that you currently work.
What Are You Currently Earning?
Let’s start with the easy parts. You’ve told me the following. Your gross salary is £40,000, for which we can work out your income tax and NI. You get 4% match on your pension, which we will add. I’ll assume (because that you don’t mention it in your question) that you get no bonus, and that you have no deduction for a student loan.
The only complicated matter with your current situation is the business mileage. You cannot claim tax relief on mileage which is travelling to your usual place of work. It’s difficult to build this into your analysis, as it depends on whether the place 40 miles away is your usual place of work. I’m going to assume that it isn’t (your company has an office and you work off site).
There are 52 weeks in the year, you have 5 weeks off and another 1.6 weeks off for bank holidays. I’ll therefore assume that for 45.4 weeks of the year (227 days) you do an average 80 mile round trip to a place of work that isn’t your usual place of work. This means that you claim back 12p per mile, or £2,179 from work for your mileage.
However, you actually get to claim a tax rebate on that additional mileage each year.
The approved mileage rates are currently 45p for the first 10,000 miles and 25p for every mile after that. Based on our assumption, you do 18,160 miles a year, and hence your total approved amount is £6,540. This means that you can then claim back the difference multiplied by your tax rate of 40% as a tax rebate. This will be £6,540 – £2,179 = £4,361 x 40% = £1,744. Woof!
Right, so, as you can see at Moneystepper.com/question73, the value of your salary package is £40,000, plus taxable benefits of your car of £5,000, plus mileage expense of £2179, plus your mileage rebate of £1,744 and employer pension benefit of £1,600.
You then will pay taxes of £6,921 and employee’s NI of £3,354, which can be calculated using the salary calculator linked to in the show notes:
This gives you a final salary outcome of £40,277.
Right, that was the easy part!!
What Is Your Self Employed Equivalent?
Now, we need to work back as to what you need to earn being self-employed per hour to get the same salary outcome.
For the sake of ease, I’m going to imagine that you set up a limited company, as for higher incomes, this will usually be beneficial compared to being a sole trader.
The problem that we are going to have is that there are a lot of moving variables.
Let’s start with the first few variables. I’m going to assume that on the days that you work, you work 8 chargeable hours a day (that’s one variable). That is 1,816 chargeable hours in the year. However, we’ll say that for 2% of days (that’s another variable), you are off work sick and cannot earn any income. That leaves 1,780 chargeable hours in the year.
We will then need to create a “profit” rate. This is the hourly chargeable net rate, being the rate you’ll charge to the client less all the hourly costs that the business will incur. This will be very tough to work out and will involve a crazy number of variables. You see, this isn’t easy is it?
If you then pay yourself in the most tax efficient way possible, you’ll have an effect tax & NI rate for the distribution of profits from the company to yourself.
For example, if your new company made an annual profit of £50,899 for the year, you could distribute that through an efficient mix of salary and dividends in order to have an effective tax rate of 20.91%. This would then give you the same net take home value as your employed wage we calculated above of around £40,250.
You can find this figure for yourself at the salary vs dividend calculator that I’ll link to in the shownotes: Moneystepper.com/question73:
Then, working backwards, to make a company profit of £50,899 based on 1780 chargeable hours (after sickness), your company hourly profit would need to be £28.60 per hour.
You need to calculate for yourself if this figure is reasonable. If you could charge £50 per hour, this means that you could allow the company £21.40 per hour in expenses, or annual expenses of £38,085. This is again another variable that you’ll have to play with to try to work out what is realistic.
The Move To Self-Employment – A Conclusion
So, Grant, to answer your question, take it from someone who made the jump from being employed to self-employed: it’s incredibly complicated. However, what you must do before you make that leap is to throw together some prudent assumptions to see if your proposed revenue and expenses will lead to a company profit that, after your effective tax rate is applied (via a clever mix of taking salary and dividends from the company), will still lead to a salary above your current value of £40,250.
Anyone else fancy making that leap to self-employment now? Haha.
Right, well we are back on Wednesday, where we have a comparatively simple question on capital gains tax when transferring some of your property to a partner.
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