Why contractors make more money than employees

Contractors earn more money than employees do. It’s that simple.

That is because contractors charge more and can take home a lot more of their pay than employees are able to. Contractors have three major advantages: they typically charge more, they pay less in taxes, and they can deduct their expenses.

Compare the employee and the contractor

Using tax tables for the tax year 2017/2018, we can compare an employee with a contractor.

A permanent worker is paid a salary of £40,000. However, if you take into account the employers NI that is being paid by the employer, the gross earnings are really £44,393. This is the gross earnings for the worker before any taxes are applied.

After the £4,393 NI tax is paid by the employer further taxes of £9,520 are paid in PAYE and employees NI, leaving the worker £30,480.

A contractor takes home £35,893 on the same payment.

The contractor takes home £5,414 More

It’s that simple: the contractor takes home £5,414pounds more per year than the employee.

Here’s how it works for the contractor:

The contractor charges £44,393 for their services and takes the necessary steps to ensure they are outside IR35. The cost to the company is the same.

The contractor pays themselves a small salary of £9,000 per year which incurs employers NI (£115), employees NI (£100), and PAYE (£97). The rest is company profit which is subject to corporation tax (£6,703). This all leaves a distributable company profit of £28,575 which is declared as a dividend and will be subject to a further tax on dividends (£1,581).

The contractors net income after taxes is £35,893, which is 81% of their earnings.

Suffice it to say, being a contractor and working via a limited company has significant tax advantages. And that’s not all…

And contractors earn more - despite what HMRC say

HMRC use the arguments above to support the IR35 legislation and claim that there are vast numbers of "deemed employees" that are clearly dodging tax.

But, this is simply not true. And the reason is, contractors charge more than employees. They have to, because they take the risks associated with not being in a secure full time position, and they have overheads to pay for because they work for themselves - insurances, income protection, critical illness, unpaid holidays, sickness downtime. And because contractors charge more, if they actually work the same number of annual hours as their counter parts in employment, the end result is that they generate more tax revenue.

But whilst HMRC do not see it this way, the reality is, that if you manage your contracting career and keep yourself in work, the rewards are far greater than permanent employment.

Claiming expenses also helps the contractor

Everyone who works incurs expenses. You have to eat lunch. You have to take the Tube, whatever.

If these expenses are “wholly and exclusively” due to the nature of your work, to cite the definition HMRC gives for such costs—for example, watching a paid video of Game of Thrones on your mobile on the way to work does not count, as you might guess.

When the permanent employee eats lunch, it comes out of his or her own pocket. Not so the contractor.

The contractor pays for their lunch out of pre-tax expenses. This makes a considerable difference.

For example, lets assume a cost of £100 per week in expenses. This costs the permanent employee the full £100 from their net income. However, the contractor can claim these expenses resulting in only a 74 pence drop in their net income.

And the contractor can claim expenses for all of their work-related equipment, things like laptops, mobile phones, office equipment, broadband connections and so on.

And that’s still not all, there’s VAT

For many items that include VAT the contractor can offset against their input VAT charged on their invoices, representing a further ‘discount’ compared to what the employee pays.

For example, a laptop costing £2000 (inc VAT) in real terms costs the contractor £1,798 – a 25% discount. And the higher up the tax bands you go, the bigger the taxable relief on these essential work items.

What about Employee Benefits? Doesn’t change anything

Have we forgotten, though, the benefits the employee enjoys? They get paid holidays, sick pay, etc.

As it turns out, the benefits issue doesn’t change anything.

Holidays:

The permie gets paid when they are on holiday. The contractor doesn’t. Assuming the contractors takes holidays the same as the permie, this cancels out, since the company is still paying the same cost per year.

Sick pay:

Employers have to protect themselves against this, and some take out insurance to do this. This is factored into the salary they pay you and assumes an average level of risk. As a contractor you can get exactly the same insurance for a small cost and also align the risk as you see fit.

Health Insurance + Life Insurance:

This is something a contractor can purchase for a small sum. For healthy individuals, you will barely notice it as you collect your tax savings each month.

Now you know why employees become contractors

So it’s clear that there are rewards to be made by becoming a contractor. It’s that simple. You can do the maths yourself with the calculators on this site.

Updated: Tuesday, July 18, 2017

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