Class 2 and Class 4 National Insurance

Two charges, two jobs

As a sole trader you can face two separate National Insurance charges on the same profit. They look similar on your bill and do completely different things, which is why they confuse almost everyone in their first year.

• Class 4 is the money charge. It is a percentage of your profit and it funds general spending.
• Class 2 is the record charge. It is a small flat weekly amount, and what it buys you is a qualifying year towards your State Pension.

Class 4: the percentage

Class 4 is charged on your taxable profit, which is your income after allowable expenses. Turnover does not come into it.

Profit                                    £50,270
Less the lower threshold                 -£12,570
                                       ----------
Charged at 6% on the difference

Nothing is charged on the first £12,570 of profit at all.

Notice that the rate falls once you pass the upper limit, from 6% to 2%. National Insurance is not progressive in the way income tax is, which is why a large profit produces a smaller NI bill than people expect.

Class 2: the small one that matters most

Class 2 is £3.65 a week. In pure cash terms it is trivial next to your income tax bill. In long-term terms it is probably the most important number in this lesson.

If your profit is above the small profits threshold of £7,105, your Class 2 record is treated as paid automatically. If your profit is below it, Class 2 becomes voluntary.

The bit HMRC does not spell out

Voluntary sounds like optional, and optional sounds like unnecessary. It usually is not.

You need roughly 35 qualifying years to get the full new State Pension, and around 10 to get any at all. A quiet year where you deliberately skip Class 2 to save a few pounds a week costs you a qualifying year. Do that for five lean years early in your self-employment and you may find, decades later, that you are short of the full pension and paying far more to buy those years back voluntarily.

The decision is worth making deliberately rather than by accident. For most people with a low-profit year, paying Class 2 is one of the best-value things they can do with that money. Check your State Pension forecast first: if the year is already covered by employment elsewhere, you may not need it.

If you are employed as well

Plenty of sole traders also have a job. In that case you pay Class 1 through your employer's payroll on the employment income, and Class 4 on the self-employed profit, on top. Your employment may already give you the qualifying year, which changes the Class 2 decision entirely. There are annual maximum rules that can limit the total, so this is a case for checking rather than assuming.

Common mistakes

• Thinking NI is charged on turnover. It is charged on profit, after expenses.
• Skipping voluntary Class 2 without checking your record. Check the forecast, then decide.
• Expecting NI to work like income tax. The top rate falls rather than rises.
• Assuming employment covers everything. Class 1 does not remove Class 4 on your self-employed profit.