What is the difference between trading income and employment income?

All income earned in the UK must be declared to HMRC, but the type of income determines which tax rules apply. Employment income comes from working for someone else, while trading income comes from running your own business or self employment. The distinction affects your responsibilities, allowable deductions, and how tax is collected.

What is employment income?

Employment income is money you earn as an employee of a company or organisation. It includes your salary, wages, bonuses, commissions, and benefits in kind such as company cars or private health insurance.

If you are employed, your employer deducts Income Tax and National Insurance through the Pay As You Earn (PAYE) system before paying your wages. This means your tax is calculated automatically, and you usually do not need to submit a Self Assessment tax return unless you have other income sources.

Examples of employment income

• A monthly salary from a full time job.

• Commission earned by a salesperson.

• Overtime or bonus payments.

• Company benefits such as gym memberships or fuel allowances.

Employees are entitled to statutory employment rights such as holiday pay, sick pay, and pension contributions. They also have less control over tax planning because their income is taxed at source by their employer.

What is trading income?

Trading income refers to profits earned from self employment, freelance work, or running a business. This income is not taxed automatically, so you must register as self employed with HMRC and report your earnings each year through a Self Assessment tax return.

Trading income is calculated by taking your total business income and subtracting allowable business expenses. The result is your taxable profit, which determines how much Income Tax and National Insurance you must pay.

Examples of trading income

• Earnings from running a shop, restaurant, or online store.

• Fees earned by a freelance consultant or designer.

• Profits from trades such as plumbing, construction, or hairdressing.

• Self employed professional services such as accounting or photography.

Unlike employees, self employed individuals are responsible for keeping records of income and expenses, filing tax returns, and paying their tax and National Insurance directly to HMRC.

How employment and trading income are taxed differently

The key difference between the two types of income is how tax is collected and what deductions are allowed.

Employment income taxation

• Tax and National Insurance are deducted automatically through PAYE.

• You receive a payslip showing gross pay, deductions, and net pay.

• Expenses can only be claimed in limited circumstances, such as work travel or professional subscriptions.

• The employer reports earnings and pays contributions to HMRC.

Trading income taxation

• You must register for Self Assessment and file a tax return each year.

• Tax is paid on business profits, not total income.

• You can deduct allowable expenses such as rent, travel, materials, and insurance.

• You are responsible for making two payments on account each year if your tax bill exceeds £1,000.

This flexibility allows self employed individuals to reduce their taxable income by claiming legitimate business expenses, but it also brings more responsibility for record keeping and deadlines.

Allowable expenses for trading income

One of the biggest advantages of earning trading income is the ability to claim expenses against your profits. Common examples include:

• Office or home working costs.

• Travel expenses for business journeys.

• Tools, stock, and materials.

• Marketing, website, and software costs.

• Professional fees such as accountants or insurance.

Employment income, by contrast, has very limited scope for claiming deductions. Only expenses that are wholly, exclusively, and necessarily incurred for your job can be claimed, and most employees find this rule too restrictive to benefit from.

National Insurance differences

Both employees and the self employed pay National Insurance, but the rates and systems differ.

• Employees pay Class 1 National Insurance, which is deducted automatically by their employer.

• Self employed individuals pay Class 2 and Class 4 National Insurance, based on their annual profits.

This means self employed people must calculate and pay their own contributions, usually through their Self Assessment return.

Record keeping responsibilities

Employees generally have few record keeping duties beyond keeping payslips and P60s. Their employer maintains payroll records and submits information to HMRC.

Self employed individuals, however, must keep detailed records of all income and expenses for at least five years after the submission deadline. This is essential for completing tax returns accurately and complying with Making Tax Digital (MTD) requirements.

When you can have both types of income

It is common for people to earn both employment and trading income. For example, someone might work full time as an employee and also earn freelance income on the side.

In this case, PAYE will cover tax on your employment income, but you must register for Self Assessment to report your trading profits separately. HMRC then calculates your total tax liability across both income sources.

This mixed income approach offers flexibility but also increases the importance of proper record keeping and accounting support.

Example in practice

Consider two individuals earning £40,000 a year each.

• The first works as an employee for a company. Their tax and National Insurance are deducted automatically through PAYE, and they have little control over how tax is applied.

• The second is a self employed graphic designer. They earn the same amount but can deduct £5,000 in business expenses for equipment, software, and marketing. They pay tax only on £35,000 of profit, reducing their overall liability.

This shows how trading income can offer more flexibility but also requires active management to stay compliant.

How accountants help with trading income

An accountant helps self employed individuals and business owners manage their tax efficiently by:

• Registering them for Self Assessment.

• Preparing accurate tax returns and accounts.

• Identifying allowable expenses to reduce tax bills.

• Managing VAT registration and Making Tax Digital compliance.

• Advising on cash flow, bookkeeping, and quarterly payments.

For employees with side businesses, an accountant can ensure that both income types are reported correctly to avoid overpaying tax.

Conclusion

The main difference between trading income and employment income lies in how you earn and report it. Employment income comes from working for an employer and is taxed automatically through PAYE, while trading income comes from running your own business and requires you to manage your own tax obligations.

Understanding this distinction helps you stay compliant with HMRC, plan your finances effectively, and make informed decisions about your business or career. With support from an accountant, managing either form of income becomes simpler, more accurate, and more tax efficient.