Embarking on a self-employed journey offers a plethora of benefits, including flexibility, the potential for greater earnings, and the opportunity to bring your unique vision to life. However, it also comes with its own set of challenges, particularly when it comes to managing finances and understanding the complexities of self employed payroll, should you decide to expand your venture by hiring employees.
This guide aims to shed light on the crucial aspects of setting up a payroll system for the self-employed in the UK, highlighting the right time to do so and providing a step-by-step approach for effective implementation.
Understanding the need for payroll
As a self-employed individual, the concept of payroll might not cross your mind until you find yourself in need of additional help. Hiring employees signifies growth and expansion but also introduces the necessity for a structured payroll system to ensure compliance with HM Revenue & Customs (HMRC) regulations and the efficient management of employee payments and tax contributions.
When is the right time to set up payroll?
Deciding on the optimal time to set up payroll hinges on several factors:
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- Hiring employees: The moment you decide to hire your first employee, it’s crucial to set up a payroll system. The UK law mandates that you register as an employer with HMRC before the first payday, but no later than four weeks after employing someone.
- Growth and scalability: As your business grows, managing financial responsibilities becomes more complex. Implementing a payroll system early can help streamline these processes, making it easier to scale your operations.
- Regulatory compliance: Staying compliant with tax laws and employment regulations is vital. A payroll system helps manage these obligations, reducing the risk of penalties.
Setting up payroll for yourself, even without employees
Setting up a payroll for oneself as a self-employed individual in the UK, even in the absence of employees, is an option worth considering. This approach, often seen in the context of sole directors of limited companies, can offer both advantages and disadvantages. Here’s an overview to help you weigh the decision:
Pros
1. Tax efficiency
Setting up a payroll can be a tax-efficient way to extract money from your business. By paying yourself a salary up to the tax-free personal allowance, you can minimise your personal tax liability. Additionally, combining this with dividend payments can optimise your overall tax position, taking advantage of lower dividend tax rates compared to income tax rates on higher salaries.
2. National Insurance Contributions (NICs)
Paying yourself a salary through payroll can help you accrue qualifying years towards your State Pension and entitlement to other state benefits. Earning a salary above the Lower Earnings Limit (LEL) but below the threshold for paying NICs can still contribute towards your National Insurance record, without actually having to pay contributions.
3. Professionalism and clarity
Having a formal payroll setup for yourself establishes a clear distinction between personal and business finances. It can enhance the professionalism of your business operations, making it easier to demonstrate salary withdrawals to financial institutions or when applying for loans.
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Cons
1. Administrative burden
Running a payroll involves additional administrative tasks, such as record-keeping, reporting to HMRC, and ensuring compliance with tax filing deadlines. This can be time-consuming, particularly for those who prefer to focus on core business activities.
2. Costs
While there are free payroll software options available, many come with limitations. Investing in comprehensive payroll software or hiring an accountant to manage payroll duties incurs costs. These expenses might outweigh the benefits for very small businesses or sole traders.
3. Complexity
Navigating the complexities of tax codes, NICs, and payroll regulations can be daunting, especially for those without a background in finance or accounting. Mistakes in payroll can lead to penalties from HMRC, making it imperative to manage these responsibilities accurately.
How to set up self-employed payroll
Setting up payroll requires careful planning and attention to detail. Follow these steps to ensure a smooth process:
How to set up self employed payroll
- Register with HMRC
Before anything else, you need to register with HMRC as an employer. This can be done online and must be completed before the first payday.
- Choose a payroll software
Select payroll software that is compatible with HMRC’s Real Time Information (RTI) system. This software will help you manage payroll calculations, generate payslips, and report to HMRC. There are various options available, ranging from free to paid services, depending on the complexity of your payroll needs.
- Collect employee details
Gather personal and financial information from your employees, including their National Insurance number, tax codes, and previous P45 forms (if applicable). This information is crucial for setting up their payroll records accurately.
- Determine pay periods
Decide how frequently you will pay your employees: weekly, bi-weekly, or monthly. This will depend on the nature of your business and your financial planning.
- Calculate payments and deductions
Use your payroll software to calculate each employee’s gross pay, taking into account their hourly rate or salary. Then, deduct taxes, National Insurance contributions, and any other deductions (e.g., pension contributions) to determine the net pay.
- Submit RTI reports to HMRC
Every time you run payroll, you must submit an RTI report to HMRC, detailing payments and deductions for each employee. This is usually done through your payroll software.
- Provide payslips to employees
After processing payroll, generate and provide payslips to your employees. Payslips can be electronic or paper-based and must detail their earnings before and after deductions, as well as the amounts for each deduction.
- Pay HMRC
Finally, you need to pay HMRC the collected taxes and National Insurance contributions. This is typically done on the 22nd of the month (or the 19th if paying by cheque) following the tax month when the deductions were made.
Other ways to pay yourself as a self-employed person, without using payroll
For self-employed individuals, particularly sole traders and partners in partnerships, the traditional payroll system may not be applicable or necessary. Instead, there are alternative methods to withdraw money from your business for personal use, ensuring both simplicity and compliance with tax regulations. Here’s a look at some of these methods:
1. Taking drawings
Drawings refer to the act of withdrawing money from your business earnings for personal use. This method is commonly used by sole traders and partnerships. Unlike a salary, drawings are not considered a business expense and therefore do not reduce your taxable income. When preparing your annual Self Assessment tax return, you’ll pay Income Tax and National Insurance Contributions based on your business’s profit, not the amount you’ve drawn from the business.
2. Dividend payments
If you’re operating through a limited company, paying yourself through dividends is a viable option. Dividends are payments made to shareholders out of the company’s after-tax profits. While dividends are taxed at a different rate than salary, they do not attract National Insurance contributions, potentially offering a tax-efficient way to extract money from your company. It’s essential to ensure that dividends are only paid out of available profits after corporation tax has been accounted for.
3. Director’s loan
Another method for limited company directors is taking a director’s loan. This involves borrowing money from your company, which you are then obliged to repay. There are specific rules and tax implications associated with director’s loans, particularly if the loan is not repaid within nine months and one day of the company’s year-end. It’s crucial to manage director’s loans carefully to avoid unintended tax liabilities.
4. Salary as a director
Although technically involving payroll, paying yourself a small salary as a director of a limited company, combined with dividends, can be a tax-efficient strategy. By paying a salary up to the National Insurance threshold, you can ensure you’re earning enough for the year to count towards your State Pension, without incurring National Insurance contributions.
5. Investing in a pension scheme
Investing in a pension scheme is an efficient way to pay yourself in the form of future financial security. Contributions made to a pension scheme can be deducted from your taxable income, lowering your immediate tax liability. For limited company directors, pension contributions can also be treated as an allowable business expense, further reducing the corporation tax liability.
FAQ about self-employed payroll
Self-employed payroll refers to the process by which self-employed individuals or business owners manage salary payments, either to themselves (in the case of sole directors of limited companies) or to their employees, including the calculation of taxes and National Insurance contributions.
If you operate as a sole trader, you typically do not need to set up a formal payroll system for yourself. However, if you’re a director of a limited company, setting up payroll to pay yourself a salary is necessary.
You must register as an employer with HMRC online before the first payday but no later than four weeks after hiring your first employee. This can be done through the HMRC website.
Yes, you can run payroll yourself using payroll software that complies with HMRC’s Real Time Information (RTI) system. It requires accurate record-keeping and timely submissions to HMRC.
Choose payroll software that meets your business needs and is compatible with HMRC’s RTI system. There are many options available, ranging from free to paid services.
You’ll need personal and financial information, including their National Insurance number, tax code, and previous employment details (P45).
This depends on your business structure and agreement with your employees. Common pay periods include weekly, bi-weekly, or monthly.
RTI submissions are real-time information reports sent to HMRC every time you run payroll, detailing payments and deductions for each employee.
Your payroll software will calculate these deductions based on each employee’s earnings and the information you’ve entered, such as their tax code and National Insurance category.
A payslip is a document provided to employees each payday, detailing their gross pay, deductions, and net pay.
Yes, it’s a legal requirement in the UK to provide employees with a payslip on or before their payday.
You typically pay HMRC through a bank transfer or Direct Debit, based on the total taxes and National Insurance contributions deducted from employee salaries.
You must keep payroll records for at least 3 years, including details of employee payments, deductions, leaves, and sickness absences, among others.
Sole traders typically do not pay themselves a salary in the traditional sense. Instead, they take drawings from their business profits.
Late submissions can result in penalties from HMRC, which vary depending on the size of your business and the frequency of missed or late reports.
You can correct mistakes by submitting an Earlier Year Update (EYU) or through your next RTI submission, depending on the type of error and when it occurred.
Yes, pension contributions for both employees and employers can be calculated and deducted through the payroll system.
The Employment Allowance allows eligible businesses to reduce their annual National Insurance liability, offering some relief on payroll costs.