Safeguarding your earnings
As a contractor, financial management takes on a new dimension without the safety net of a regular monthly salary or in-house HR. In this chapter, we’ll look into necessary financial considerations, and help you get to grips with taxation, invoicing, savings, and more, making sure you're both compliant and financially sound.
Understanding taxes
It’s important to have a clear understanding of your tax obligations as a contractor. If you're operating through your own limited company, you'll need to manage Corporation Tax, PAYE for any salary you take, VAT if you’re VAT registered, and tax on any dividends.
If you have an accountant, they can handle all your tax management for you.
Here’s a breakdown of the primary taxes you'll come across and what they mean:
Corporation Tax
This tax is required from your company's profits, which is the net income after allowable business expenses have been deducted. It's a fundamental tax that all limited companies need to pay. Unlike personal income, where tax brackets can vary, Corporation Tax is charged at a flat rate on all profits. That’s why it’s important to accurately report your profit. It can also influence any decisions about salary and dividend distributions.
Pay As You Earn (PAYE)
If you're taking a salary from your limited company, PAYE applies. PAYE is the system used to collect Income Tax and National Insurance contributions from employee salaries. If you operate through your own company and plan to pay yourself a salary, you’ll need to set up a PAYE scheme. That way, you can be sure that the taxes on your salary are paid throughout the tax year.
Value Added Tax (VAT)
VAT applies to most goods and services sold in the UK. As a VAT-registered contractor, you charge VAT on the services you provide and can reclaim VAT on business-related purchases. When dealing with VAT, you should keep detailed records and tell HMRC how much VAT you’ve charged and paid, typically every quarter. This makes sure you only pay HMRC the net VAT, which is the difference between the VAT you collect from clients and the VAT you pay on purchases. Being VAT-registered can also show your clients that you’re professional and can manage your finances well.
Managing VAT efficiently
As a contractor, it’s important to successfully handle VAT, so you can keep compliant with regulations, enhance your professionalism, and stay competitive in your industry.
Here’s what managing VAT involves:
Charging VAT
Add a 20% VAT charge, known as output tax, to your invoices. This shows that the VAT you’re collecting from your clients is on behalf of HMRC.
Reclaiming VAT
You can reclaim the VAT paid on business purchases, known as input tax. Items that qualify as business purchases include things like office supplies and professional software. Reclaiming VAT is great for your business because you’re ultimately reducing your net VAT payment to HMRC. Here’s a full list of business expenses that qualify for reclaiming VAT:
VAT returns
You have to submit your VAT returns to HMRC every quarter. These VAT returns should list the output tax you’ve charged, and the input tax you’ve paid and want to reclaim. If you’ve paid more VAT than you’ve charged, you might be entitled to a refund. If you’ve charged more VAT than you’ve paid, you’ll owe more VAT to HMRC.
Streamlining VAT with digital tools
Try out digital tools tailored to VAT calculations and reporting. Choosing the right one can significantly streamline the way you manage VAT. Check out tools like:
Dividend tax
If you decide to take part of your income as dividends, it’s important you understand dividend tax. Dividends are a portion of profit paid to shareholders, and are taxed differently and usually in a more favourable way than a regular salary. If your dividends go over a certain amount, you’ll need to pay dividend tax on them. The way you split your earnings between your salary and dividends can make a big difference to how much tax you end up paying.
Tax-deductible expenses
When you know which expenses you can claim back on your taxes, you can reduce the amount of profit you’re taxed on, which means you pay less Corporation Tax. These types of expenses could be things like office supplies or business travel.
Here’s a full list of items that count as tax-deductible expenses.
Understanding these different tax areas will help you follow the rules and keep your company's finances in good shape. Managing taxes might seem overwhelming, but using the right tools and getting good advice can make it easier. That way, you can focus on growing your business and delivering value to your clients.
- Submit your annual accounts to HMRC.
- Keep track of your expenses to reduce your taxable income.
- Charge VAT if you’re registered, and submit your VAT returns every quarter.
- Consult a specialist accountant for complex tax issues.
Understanding timesheets and invoicing
In this section, we’ll explore the important details surrounding timesheets and invoicing for contractors, both inside and outside IR35. Regular invoicing will become a critical part of your routine, crucial for getting paid on time and keeping transparent financial records. There are four key steps to getting paid.
Step 1: Submit your timesheets
Timesheets are an essential tool for contractors to record and submit the number of hours worked during a specific period to their client, typically weekly or monthly. They serve as a basis for invoicing and getting paid accurately. Usually, your recruitment agency will tell you all you need to know about the timesheet process. This can vary depending on the agency and client you’re contracting with. Here’s a real-world example of a timesheet.
Step 2: Submit your invoice
An invoice is critical to getting paid on time and building positive relationships with your clients. It’s a legal requirement that’s helpful for record-keeping, financial planning and managing audits. Typically, you’ll submit your invoice to your recruitment agency. A comprehensive and detailed invoice can prevent delays and disputes, while being a key part of your financial management strategy.
The details matter. Your invoice should include:
Your company’s name, address, and contact details
Your company’s registration number, if you have one
Your VAT registration number, if you’re VAT registered and are charging VAT on your invoice
The invoice date and a unique invoice number
Client’s name, address, and contact details
A clear description of the services you’ve provided
The amount being charged and any applicable VAT
Payment terms, for example, "Payment due within 30 days", and if you’ve agreed to charge late fees, “Late payments will incur a [X]% fee to cover admin costs and encourage on-time payment.”
Use a tax or VAT calculator
If you're VAT-registered, you can charge an extra 20% VAT on your invoices. If you’re using a calculator, enter the amount before tax, apply an extra 20% VAT, then you’ll see the VAT and total amount due. For example:
Invoice example
Here’s an example of what your invoice might look like, along with a short guide.
Choose an accounting software
When you’re choosing an accounting invoicing software, prioritise one that can track your finances and generate invoices, too. Consider platforms like:
Here are some key points you need to remember when it comes to invoicing:
Stay organised: Keep copies of all invoices you send, and make a note when they're settled. This will be helpful for financial tracking and tax purposes.
Set clear payment terms: To avoid delayed payments, be transparent about your payment terms from the outset. Clarify when the payment is due and which payment methods you accept.
Chase late payments: Sometimes clients might overlook or defer payment. Politely remind them if the payment becomes overdue. If late payments continue, consider introducing late fees.
Step 3: Communicate with your agency to get paid
You’ll need to send your invoice to your recruitment agency, so you can get paid for your work. It’s important to stay professional and encourage open communication, in case the agency has questions or needs any clarification.
You can use this template to start communicating with your agency:
Step 4: Follow up with your agency if necessary
If you haven’t received your payment on time, here’s an email template you can use to follow up with your recruitment agency.
Budgeting for downtime
As you know by now, contracting can be unpredictable. You may have spells without work, and the uncertainty of when you’ll get your next contract can be challenging, so it's important to budget for these downtimes. Check out these tips:
Rainy day fund: Try to save at least three to six months of living expenses to cover your costs during long periods without work.
Set a portion of your income aside
Regular savings: During your lucrative months, consistently add a fixed amount of your income to a savings account. Before you know it, you’ll have saved enough over time to financially support you during slower times.
Variable cost strategy: It’s smart to adjust your spending based on your income. During busy periods, set aside a higher amount to your savings, and when it’s quieter, you can reduce this amount.
Separate your business and personal expenses
Business bank account: Opening a separate business account means that all your professional income and expenses are in one place. That way, you can get a headstart in clear financial management and simplified tax calculations.
Clear financial overview: You can easily identify your monthly business overheads and personal living costs, which will help you figure out how much you need to set aside.
Regular financial check-ins
Monthly reviews: Dedicate time at the end of each month to review your finances. Analyse your earnings, savings, and expenditures, and tweak your budgeting strategy if you need to.
Anticipate low seasons: Some industries have predictable downtimes. If you're aware of these, you can adjust your budget and savings strategy in advance.
Diversify your income streams
Multiple clients: Try not to rely on a single client or project. Diversify your client base for a level of income stability, as the end of one contract might coincide with the start of another.
Passive income: Consider avenues for passive income, like investing in stocks or property*. These can boost your earnings during slower contracting periods.
*This isn’t financial advice. If you're thinking about investing, it’s worth speaking to a qualified advisor first.
The key is to plan ahead. Be proactive, so you can get through the unpredictable nature of contracting and keep your finances resilient, no matter your circumstances.
Saving for the future
Saving for the future is essential for financial stability and achieving your long-term goals. As a contractor, you won't have access to an employer's pension scheme, so you'll need to make your own arrangements.
Two effective ways to save for the future are through pension plans and Individual Savings Accounts (ISAs), each offering a set of unique benefits.
What are pensions?
Pensions are a cornerstone of retirement planning. They provide a structured way to accumulate funds for your later years, and often come with tax benefits. There are three types of pensions relevant to contractors: personal pensions, Self-Invested Personal Pensions (SIPPs), and stakeholder pensions. Choosing between them depends on your specific needs, financial goals, and how actively you want to manage your investments. Here’s a brief overview of each one:
Personal pensions: These are managed by pension companies, offering a straightforward, hands-off savings approach for retirement. This option is ideal if you’re looking for simplicity and minimal involvement in investment decisions.
SIPPs: These are managed by you, giving you flexibility and control over your investment choices. If you’ve got investment knowledge and want to actively manage your retirement savings, a SIPP could be a good choice.
Stakeholder pensions: These pensions offer a middle ground between personal pensions and SIPPs, with low fees and flexible contributions. With a stakeholder pension, you can stop, start or change your contribution levels without penalty.
Pension types for contractors
Now that we’ve explored each pension type, let’s go into more detail. We’ll help you understand the unique features of each one, and identify some companies that offer these services.
Personal pensions
This type of pension is a great choice if you’re looking for a hands-off investment approach, and if you value ease and convenience in your retirement planning. It offers a balance of professional management and tax efficiency. Here's what you need to know:
Simple to set up and manage: This makes a personal pension ideal if you’d rather not get involved in the day-to-day management of your investments.
Hands-off investment approach: The pension provider manages the investments on your behalf, selecting funds that align with your risk tolerance and retirement goals.
Lower fees than SIPPs: This is due to the more passive investment approach, but it's important to compare providers to find the best deal.
Tax benefits: Like SIPPs, your contributions are eligible for tax relief, which effectively increases the value of your investment.
Flexibility to access your savings: You can typically start drawing from your personal pension from the age of 55, with a range of options for accessing your funds.
SIPPs
This type of pension strikes a balance between control over your investments and tax benefits. It’s a useful option if you’re an experienced investor and want to actively manage your retirement funds. Its features include:
Flexible investment choices: SIPPs allow you to diversify your portfolio with a range of assets, including stocks, bonds, funds, and property, so you can tailor your investment strategy to your personal financial goals.
Hands-on, active management: If you’ve got a strong interest in financial markets and want to take an active role in your investment decisions, a SIPP could be an ideal option for you.
Higher costs and fees than personal pensions: Although they offer a broad range of investment options, keep in mind that SIPPs may come with higher fees than traditional pensions.
Tax efficiency: Your contributions will benefit from tax relief, which can increase the value of your retirement savings. You can also access up to 25% of your savings as a tax-free amount, from the age of 55.
Stakeholder pensions
This pension type is designed to be a low-cost and flexible solution with minimal management requirements. If you don’t have a steady income or you’re new to pension savings, it could be right for you. The key points to consider include:
Low charges: Stakeholder pensions are subject to strict charging caps to keep costs low, so they can be an economical choice for your retirement savings.
Diverse investment options: They offer fewer investment choices than SIPPs, but still provide enough diversity to meet your needs, with investments managed by the provider.
Flexible contributions: They allow you to start and stop payments without penalty. This is helpful for people with fluctuating incomes, like contractors and freelancers.
Easy to use: Stakeholder pensions are straightforward to set up and don’t need much ongoing management, which is great if you seek simplicity.
Tax benefits and pension access: You benefit from tax relief on your pension contributions, effectively reducing the cost of saving for your retirement. All taxpayers get immediate tax relief: if you pay basic tax (20%), every £80 you contribute is topped up to £100 by the government. Higher and additional rate taxpayers can claim even more relief. From the age of 55, you can access your pension with the option to withdraw up to 25% as a tax-free lump sum.
Choosing the right approach
Deciding to take advantage of all three pension types, or just one, depends on your personal circumstances and retirement goals. Let’s review the two options to help guide your decision.
Choosing one pension
If you value simplicity and ease of management, consider a single pension plan. A personal pension might be best if you prefer a more hands-off approach to retirement savings, as you won’t need to actively manage your own investments.
Choosing two or more pensions
If you’re comfortable with a more complex approach to saving for your retirement, you can diversify across multiple pension types. Key benefits include:
Diversification: Spreading your retirement savings across different pension types, like a personal pension, SIPP, and stakeholder pension, means you can potentially reduce risk. Choosing multiple pensions lets you take advantage of different investment strategies and markets, which could lead to a more robust retirement portfolio.
Flexibility over simplicity: Single pension plans offer simplicity, but combining a SIPP with a personal or stakeholder pension offers more flexibility to actively manage part of your retirement savings. If you’re seeking potentially higher returns and a more hands-on, flexible approach, using more than one pension could be a smart choice.
Growth potential and security: Your long-term financial goals and retirement plans play an important role in whether you choose one pension or multiple. If you want to maximise your retirement savings and can handle the complexity of managing investments, combining pensions could provide growth potential and security.
Some contractors may find that focusing on one type of pension best aligns with their needs and investment style, while others may prefer a diversified approach of combining different pensions. You might want to consult a financial advisor to tailor a retirement planning strategy that works with your individual circumstances and financial goals.
ISA overview
ISAs offer a flexible way to build and access your savings, without the tax constraints that typically apply to other types of investment income. Their variety and flexibility make them a great tool in any strategy for saving for the future.
Here’s some more information about ISAs:
Tax-free earnings: ISAs allow earnings (interest, dividends, or capital gains) to grow tax-free, helping you maximise your savings potential.
Annual allowance: You can save up to £20,000 in your ISA or split the allowance across multiple accounts every tax year which runs from 6 April to 5 April (according to Gov.uk in 2024).
Your ISA allowance can’t be carried over: ISA allowances are reset every tax year, so you can’t carry any unused portion over to the next tax year. It’s possible to use all or part of your ISA allowance, but it’s better to make the most of it to improve your financial security.
Flexible cash withdrawal: You can withdraw funds from your ISA at any time, without any tax penalties. Make sure you check the terms of your ISA to see if there are any rules around withdrawing your money.
Diverse types of ISAs: These include Cash ISAs, Stocks and Shares ISAs, Innovative Finance ISAs (IFISAS), and Lifetime ISAs (LISAs). They all serve different saving and investing preferences.
Cash ISA
A Cash ISA offers a secure, low-risk, and tax-free way to save money. It’s similar to a standard savings account, but with the added benefit of earning interest without paying tax. Its benefits include:
Security: Cash ISAs provide a risk-free return on the money you save.
Accessibility: Most Cash ISAs allow easy and instant access to your funds, but some may offer better interest rates for fixed-term or limited access accounts.
Fixed-rate Cash ISAs available: Cash ISAs with a fixed interest rate provide predictable returns because the interest rates don’t change during your term.
Tax efficiency: You’ll earn tax-free interest on the money you save, enhancing the return on your savings.
Inflation decreases real-term value of savings: Holding your cash in an ISA long term means that while you benefit from tax-free interest, the value of your savings could decrease in real terms because of inflation—especially if interest rates are lower than the inflation rate.
Stocks and Shares ISA
Stocks and Shares ISAs let you invest in a mixture of financial assets, including stocks, bonds and mutual funds. With this type of ISA, there’s potential for higher returns than Cash ISAs, but it carries greater risk. If you’re looking for tax-efficient growth over the medium to long term, and are comfortable with investment risk, this could be a good route to take. The good things about Stocks and Shares ISAs include:
Potential for higher returns: Over the long term, stocks and shares typically outperform cash savings.
Tax benefits: You won’t need to pay capital gains tax on any profit you make, or tax on your dividend income, making it an efficient way to grow your investment.
Investment options: You get access to a wide range of investment choices, from individual stocks to managed funds.
- Investment risk: Your capital is at risk and returns are not guaranteed.
- Higher risk than Cash ISAs: Investing in a Stocks and Shares ISA offers the potential for higher returns compared to Cash ISAs, but this comes with higher risk, too.
- Market fluctuations: Changes in the market can impact the value of your investments. That’s why it’s important to think about how comfortable you are with taking risks and the amount of time you plan to invest.
Lifetime ISA
This type of ISA is designed to help you save up for your first home or retirement. You can put in up to £4,000 every tax year until you’re 50 years old, and the government will add a 25% bonus on top of the money you save. The annual ISA limit is £20,000 for the 2024 to 2025 tax year (according to Gov.uk in 2024). Here are some of its key benefits:
Government bonus: You’ll get a 25% bonus on your contributions every tax year until you’re 50 years old, helping you save more.
Use for property: You can use your savings to buy your first home up to £450,000, at least 12 months after making the first payment into your ISA.
Save for retirement: You can withdraw your cash without a 25% charge once you hit 60 years old.
- Penalties for early withdrawal: If you take your money out before you’re 60 for other reasons than buying your first home, you’ll lose the government bonus and a portion of your savings. Think about your financial stability and long-term commitment before you choose a LISA.
- Contribution limits: Your contributions count towards your annual ISA limit.
Innovative Finance ISA (IFISA)
With an IFISA, you can use your ISA allowance to lend or borrow money, through peer-to-peer loans and debt-based crowdfunding. Key benefits include:
Potential for higher returns: You can typically earn better returns than with an ordinary savings account or Cash ISA.
Peer-to-peer lending: Lend or borrow money from individuals or businesses, without needing to go through a bank. If you lend money, you can get a better return on your investment, and if you borrow money, you can pay lower interest rates than you would with a traditional bank account.
Flexibility: There are lots of websites and platforms you can use, and they all offer different types of loans and terms.
- Investment risk: Your capital is at risk and returns are not guaranteed.
- Lack of protection: If there’s any loss or problem with your IFISA, you won’t be covered or compensated by the Financial Services Compensation Scheme (FSCS).
In the next chapter, we'll explore how to market yourself effectively. This includes building your brand, networking, and using social media to make connections and attract more clients.
Financial breakdown for Chapter 8
Find out how much it could cost to get financial management tools and services.
Monthly or annual fees for financial management software.
Estimated cost range: £10 to £40 per month
Regular consultations with a financial advisor to manage your finances.
Estimated cost range: £220 to £1,480 annually
Total estimated cost range
Action Checklist: Managing your finances as a contractor
Complete this checklist to make sure you're on top of financial management and compliance.
Managing your finances as a contractor
