Money management for contractors

Contractors have much more than just household bills to worry about when managing their money. There’s tax to pay, business expenses to cover, and income to calculate. Plus, importantly, contractors have to factor in the cost of taking planned and unplanned time off.

But by staying organised, and with the help of a good accountant, contractors can manage their money and still focus on the benefits of contracting, such as choosing to do the work they enjoy most, taking more time off and taking home more of their earnings.

Tax – company and personal

Employees have tax deducted at source and rarely have to complete a tax return. Limited company contractors, on the other hand, have to juggle:

• Corporation tax – usually paid once a year, nine months after year end
• Income tax via a Pay As You Earn (PAYE) payroll – usually paid monthly
• Employee’s National Insurance Contributions (NICs) – usually paid monthly via PAYE
• Employer’s National Insurance Contributions – usually paid quarterly
• Value Added Tax (VAT), which they collect on behalf of the government – usually paid quarterly, or annually
• A company tax return and personal self assessment tax return must be submitted annually, usually completed by an accountant.

In practice, VAT and corporation tax are the taxes that most concern contractors who pay themselves a salary up to their personal allowance. That usually requires contractors to make a major VAT payment quarterly and an annual corporation tax payment.

Expenses – business and hidden expenses

Everyone has personal expenses and household bills, but employees, beyond their company travel and subsistence expenses, rarely have to worry about whether the company phone bill was paid last week, or if professional indemnity insurance is up to date. Key expenses for contractors include:

• Limited company operating expenses, such as insurances, accountancy and legal fees, communications like smartphones and broadband, equipment like computers and personal protective clothing, travel and subsistence, company vehicles and entertainment
• ‘Hidden’ expenses such as pensions, death in service insurance and life assurance, health assurance, private health cover (the many benefits which come with employment).

Many of these expenses are annual, one-off costs and others will be monthly. They can add up to a tidy sum, but for most contractors they represent a small proportion of their fee income and can be offset against tax. Contractors should ensure they budget for all these costs so they don’t experience sudden cashflow challenges, particularly if they are between contracts.

Time off – holiday, sickness and periods between contracts

Employees get paid for taking time off, but contractors actually pay for the privilege! But it’s not as bad as it sounds, because contractors generally earn more than employees and so can afford to take more time off if they wish to. The important thing is for them to prepare well and budget accordingly. Here’s what contractors need to know about managing their money for holidays, sickness and periods between contracts:

• Contractors don’t get paid when they don’t work (statutory sick pay won’t pay many bills)
• But contractors generally earn considerably more than permanent counterparts who do get paid for time off
• Contractors choose how much and when to take income from their business; this means they can be earning a significant sum over, for example ten months of the year but take payments over twelve months to allow for two months of holidays
• Contractors should have a minimum three to six month cash buffer to cover all business and personal costs in case they can’t find work, or can’t work due to short-term illness or family emergencies
• Contractors can choose to buy a specialist income protection policy that will provide an income if they have an accident or long-term medical condition.

In practice, most contractors tend to take more holidays and have less time off sick compared to permanent employees. Having higher earning power and much greater control over their money allows contractors this freedom.

Income – when, what and how to pay

Employees typically get paid a set monthly amount, after deductions for tax and NICs, and some enjoy sales commissions and bonuses as part of their remuneration. Contractors can choose what, how and when they wish to be paid, usually a combination of low salary and high dividend. But contractors must only pay themselves what their business can afford. Here’s why:

• Money management basics include creating a monthly budget of personal and business outgoings and income; Contractor Calculator’s online interactive calculators can help with budgeting, especially when forecasting tax liabilities
• Contractors should remember to deduct their allowable business expenses, including a salary up to the tax free personal allowance limit, from their gross fees, and then make a provision for corporation tax. That provides them with a rough profit each month
• Profit can be paid out as a dividend to the contractor, or retained in the company. This is where contractors have so much more flexibility over managing their money than employees
• Excess profits over and above what the contractor needs to live during periods of high fees can be retained in the company to pay the contractor during periods of holiday, sickness or between contracts
• Contractors can invest their company’s money to make it work a bit harder, rather than losing value on money held in a low or no interest accounts.
• Contractors may also find that it makes sense to extract excess profits and pay off some of their mortgage. Read more about this.

New contractors shouldn’t worry if the above looks complicated because, with the help of a contractor accountant, it really isn’t. Money management for contractors is very straightforward as long as contractors are organised and factor in all of the above points, allowing them to enjoy the benefits that a contracting lifestyle can bring.