Going self-employed

The second-year cash flow shock

This is the single most common problem, and it's entirely predictable.

In your first year you earn, and pay nothing until the following 31 January. That feels generous.

Then on that 31 January you pay the tax for the year just gone and a payment on account towards the next year, typically half again. Then another payment on account on 31 July.

So the first bill is often around 150% of what you expected, arriving in January, when nobody has spare money.

The defence is simple and almost nobody does it from the start: open a separate savings account and move a percentage of every payment you receive into it the day it arrives. Somewhere between 25% and 40% depending on your income level and whether you're above the VAT threshold. Treat that account as not yours.

Do this from your first invoice, and the January bill is an administrative event rather than a crisis.

What you've lost

Employment came with things that were invisible until they stopped.

Sick pay. No statutory sick pay for the self-employed, and no employer scheme. If you can't work, income stops immediately.

Death in service cover, which most employees have and few know the value of.

Employer pension contributions. This is the big one financially — an employer paying 5% or more into your pension was part of your package, and it's now entirely on you.

Paid holiday, which means every day off has a direct cost.

Redundancy rights and notice periods.

What that means you need

A bigger emergency fund. Three to six months is the general guidance; for self-employed people with variable income, six to twelve is more realistic. See Your emergency fund.

Income protection, which matters more here than for almost anyone else, precisely because there's no sick pay behind you. Insurers will want evidence of earnings, usually accounts or tax returns over a couple of years — which is an argument for arranging it early, since the newly self-employed can find cover harder to get. See Income protection.

Your own pension. Nobody is going to do this for you, and the absence of an employer contribution means the burden is higher, not lower. A personal pension or SIPP with a monthly contribution, set up at the start, avoids the very common pattern of intending to sort it out once things settle down and never doing so.

Contributions are limited to 100% of your relevant earnings, which for the self-employed means profits rather than turnover. See How much should you be paying in?.

National Insurance and your State Pension

Self-employed National Insurance has changed in recent years, and the relationship between what you pay and what you build up isn't as obvious as it used to be.

What matters is that your profits still generate qualifying years towards the State Pension, and that in a year of low profits you may need to consider voluntary contributions to avoid a gap.

Check your State Pension forecast annually once you're self-employed. Gaps are much easier to spot and fill at the time than a decade later. See Your State Pension.

Sole trader or limited company

Sole trader is simpler. You are the business, profits are taxed as your income, and the administration is light.

A limited company is a separate legal entity. It can be more tax-efficient at higher profit levels, particularly through a mix of salary and dividends, and it limits your personal liability. It also brings more administration, more filing deadlines, and public accounts.

The tax advantage has narrowed considerably — dividend allowances have been cut sharply and corporation tax rates have risen — so the calculation that made incorporation obviously worthwhile a decade ago no longer holds automatically.

There's no profit level at which the answer flips universally. It depends on how much you need to draw, whether you have other income, and how much administration you'll tolerate. It's genuinely worth an accountant's view rather than a rule of thumb.

Records and expenses

Keep everything from day one. Reconstructing a year of records in January is miserable and expensive.

Know what's allowable. Genuine business expenses reduce your taxable profit. The rules around use of home, vehicles and anything with a personal element are more restrictive than people assume, and getting them wrong in your favour is worse than getting them wrong the other way.

Consider an accountant, particularly for your first return. The fee is deductible and they will usually find more than they cost — but more importantly they stop you making a structural mistake that persists for years.

If you're leaving employment to do this

Two things to sort before you go, while you're still employed:

• Any protection you'll want is easier and cheaper to arrange with an employment record behind you.
• A mortgage, if you're planning to move or remortgage soon. Lenders typically want two or three years of accounts from a self-employed applicant, so the year after going independent is the hardest time to borrow.

This page is for general education only and isn't personal advice. Tax rules for the self-employed change regularly and the sole trader versus company question depends on your specific circumstances.