If you are self employed, making sure you claim all the allowable expense you are entitled to is absolutely key to keeping down your tax bill. However, the majority of sole traders find understanding how expenses are offset against their tax bill difficult and confusing. Here is a short explanation to help unravel the great expense mystery:
The way a sole trader tax bill is worked out is fairly simple (assuming you don’t have many sources of income or investments other than your business sales).
At the end of your tax year you take all of your recorded income >> 1tap tax app
– and subtract all of your business expenses >> 1tap receipts app
=Whatever you are left with, you deduct your personal tax allowance (the amount you are allowed to earn each year tax-free) and that is the amount HMRC will tax you on.
– £10,000 (expenses)
– £11,000 (personal allowance)
= £11,000 (taxable income)
This £11,000 falls into the BASIC RATE tax band (£0 – £32,000 taxable income) which means you’ll pay 20% tax = £2,200
The majority of sole traders in the UK fall into the Basic rate tax band, so this means that every £1 you spend on the business (as expenses) will save you 20% on tax – or 20p in the £1.
A common misconception by the self employed is that claiming a £100 expense (for example) will reduce your tax bill by £100. As you can see from the calculation example above, this is not how expenses work!
In reality, as a sole trader you deduct the expense from your income on your tax return. So if you spend £100 on an allowable expense for your business, that will not reduce your taxes by £100. It will reduce your taxable income by £100. Put simply, that means that if your tax rate is 20% (the most common rate for most sole traders) then you will save £20 on your taxes by making that purchase.