National Insurance Contributions (NICs) – an explainer
According to media reports the Government is considering raising National Insurance to increase spending on social care. This explainer sets out what National Insurance is, how it works and what the Government might do.
Q. What is National Insurance?
National Insurance is a tax on earnings paid by both employees (from their wages) and by employers (on top of the wages they pay out), as well as by the self-employed (from their trading profits).
Technically National Insurance is a social security contribution rather than a tax, but really, it’s a compulsory payment taken from you by the Government, so, to all intents and purposes, it’s a tax.
Q. What are the Government proposing?
There’s nothing official yet, but the reports are that the Government are planning a one per cent increase in National Insurance Contributions (NICs) to increase funding for social care – and possibly aspects of wider health care too. No announcement is expected until the autumn.
Q. Didn’t Gordon Brown do something like this?
Well remembered. In 2003 the then Labour Government raised NICs by one per cent to fund the NHS. Business leaders and Conservatives criticised it as a ‘jobs tax’ and accused Labour of breaking the spirit of their manifesto, which had promised no increases in income tax (but hadn’t mentioned National Insurance).
Q. And now?
Business leaders, some Conservatives and Labour leader Keir Starmer have said a National Insurance (NI) rise would be a ‘jobs tax’ and reminded the Government that their manifesto promised no increases in income tax or NI.
Q. So National Insurance is a tax on income, but it’s different from income tax?
Yes. In a review in 2016 the Office for Tax Simplification identified 84 ways in which income tax and NICs are different. Some of the bigger ones are -
- Income tax is levied on your annual income, whereas NICs (for employees) are levied for each earnings period (so typically monthly or weekly) without reference to any previous pay or NIC deductions
- Income tax is levied on all income (including investment, property and dividend income) whereas NICs is only levied on employment income
- National Insurance has different rates for the employed and self-employed, income tax has a single set of rates for everyone in employment
- Income tax is aggregated across all employments and other sources of income whereas for National Insurance each separate employment is treated in isolation
- Pensioners are exempt from NICs
- NICs are paid by employers as well as workers
We’ll come back to some of these points in a moment.
Q. How much does National Insurance raise?
NICs are forecast to raise £147 billion this year (2021/22). This compares with forecast receipts of £198 billion from income tax, and £128 billion from VAT. Most NICs (about four fifths) are paid into a separate ‘National Insurance Fund’, which is kept separate from all other revenue raised by taxation. The remaining fifth of NICs revenue goes to the NHS.
But if the Government raised National Insurance to spend more on social care and/or health they would need to change these proportions (as Gordon Brown did in 2003).
Q. A National Insurance Fund? What does it fund?
It funds contributory benefits such as the state pension, contributions-based jobseeker’s allowance, contributory employment and support allowance, maternity allowance, and bereavement benefits.
The fund operates on a 'pay as you go' basis; i.e. this year’s contributions pay (broadly speaking) for this year’s benefits (of which state pensions amount to about 90% of the benefits paid out).
However while the fund is limited by law (the Social Security Administration Act 1992) in terms of what it can be used for it would be wrong to think of it as a totally ring-fenced pot of money. If the fund runs low and there is a risk of there not being enough money in it to pay the benefits in question the Treasury tops it up from general government funds. If the fund builds up a good surplus then it lends money to other parts of government, effectively reducing the national debt. (Full Fact did an explainer on this particular point in 2019.)
There is no automatic relationship between the total amount raised from NICs and the generosity or otherwise of contributory benefits.
Q. Does the amount of National Insurance I pay affect the benefits I might get personally?
Yes. Payment of NICs builds up your entitlement to the state pension and to other contributory benefits, such as the ones mentioned above.
Q. How does the amount of National Insurance I pay affect my state pension entitlement?
A single-component flat-rate state pension replaced the two-component system for individuals who reach state pension age on or after 6 April 2016. The latest rules provide, broadly, that in order to get a full state pension an individual must have paid or have been credited with Class 1, 2 or 3 NICs on an amount equal to 52 times the Lower Earnings Limit (see below) in each of 35 ‘qualifying years’ of working life.
Q. You mentioned there are different rates of NICs?
Yes. It’s a bit complicated, but here goes.
As mentioned above, NICs are paid by employees, employers and the self-employed. The amounts of NICs payable and the rules for collecting it depend upon which ‘class’ of NIC is payable and the contribution rate. Class 1 (primary) is paid by employees, Classes 1 (secondary), 1A and 1B by employers, Classes 2 and 4 by the self-employed and Class 3 is for voluntary contributions.
Q. How much NI does an employee pay?
Employees are liable to primary Class 1 NICs on their earnings if they exceed the Lower Earnings Limit (LEL). The LEL is set at £120 per week for 2021/22. A zero rate of NICs is, however, charged on earnings between the LEL and the primary threshold (PT), which is set at £184 per week. In effect, while no NIC is paid on earnings between these two thresholds, an employee is treated as if they have made a contributory payment, which maintains their entitlement to contributory benefits. Earnings above the PT are charged NICs at a rate of 12%, subject to a cap at the upper earnings limit (UEL), which is set at £967 per week. Earnings above the UEL are charged NICs at a rate of 2%. Where a worker has more than one concurrent employment these thresholds are applied separately against the earnings from each job (unless the businesses are connected) (but liability to NIC is subject to an ‘annual maximum’ where combined earnings exceed the UEL, which broadly limits liability on combined earnings above the UEL to 2%).
What this means is that an employee earning £20,000 this year (2021-22) will pay £1,252 in primary Class 1 NICs in 2021-22. An employee earning £40,000 this year will pay £3,652. An employee earning £60,000 this year will pay £5,079. These calculations assume income is evenly spread through the year. (You can use Which’s National Insurance Calculator to work out how much you are due to pay this year.)
Q. How much NI do employers pay?
Employers pay secondary Class 1 NICs on employee earnings at a rate of 13.8% on earnings above the secondary threshold (ST). The ST is set at £170 a week for 2021/22. Employers are also liable to pay Class 1A NICs on benefits provided for employees, and Class 1B NICs on PAYE Settlement Agreements (PSAs) at a rate of 13.8%. There are various exemptions and allowances employers can claim, including exemptions for employees under 21, apprentices under 25 and, in the future, armed forces veterans and freeport employees (these are subject to upper limits). In addition, small employers can claim the ‘employment allowance’. This provides a flat rate deduction for businesses and charities against their annual employer NICs bill. Initially the Allowance was set at £2,000, but was increased to £3,000 from April 2016, and to £4,000 from April 2020. From April 2020 the Allowance may only be claimed by employers with an employer NICs liability below £100,000 in their previous tax year.
What this means is that for someone earning £20,000 this year their employer will pay £1,540 in secondary Class 1 NICs in 2021-22. For an employee earning £40,000 this year the employer will pay £4,300. For an employee earning £60,000 an employer will pay £7,060. These amounts are all on top of the salary paid to the employee and in addition to the employee NICs mentioned above. These calculations assume income is evenly spread through the year and no special factors, exemptions or allowances apply.
Q. How much NI do the self-employed pay?
The self-employed (including self-employed partners of partnerships) pay a weekly flat rate Class 2 NIC (set at £3.05 for 2021/22). They may apply for exemption from paying Class 2 contributions if their annual profits are less than the level of the ‘small profits threshold’ (SPT), currently set at £6,515. In addition they may be liable to pay a separate Class 4 profits related contribution. Class 4 NICs are charged at a rate of 9% on profits between a lower annual profits limit (£9,568) and an annual upper profits limit (£50,270). All these thresholds are for 2021/22. Profits above the upper limit are charged NICs at a rate of 2%.
What this means is that a self-employed person making a profit of £20,000 this year (2021-22) will pay £1,097 in NICs (Class 2 plus Class 4) in 2021-22. A self-employed person making a profit of £40,000 this year will pay £2,897 in NICs. A self-employed person making a profit of £60,000 this year will pay £4,016 in NICs.
Q. What if I’m not working but want to maintain my contributions record to qualify for the state pension?
Voluntary Class 3 contributions may be paid by individuals not liable to Classes 1 or 2 NIC to ensure that they qualify for the state pension and bereavement benefits. Class 3 NICs are charged at a weekly flat rate, set at £15.40 for 2021/22.
I told you it was complicated!
Q. And I don’t have to pay National Insurance after reaching State Pension age?
Correct. NICs are only paid by individuals below pensionable age (though employers of individuals over pensionable age are still liable for employer’s secondary Class 1 contributions). The earnings (from employment or self-employment) of individuals over state pension age are exempt from paying NICs but remain liable to income tax.
Additionally, pensions (including the state pension) are exempt from NICs (even where an individual receives a company or personal pension below state pension age) but they are liable to income tax. However, unlike with income tax, there is no NICs relief on contributions to private pensions (ie you pay NICs on the portion of your income you put into a private pension but don’t pay income tax on it).
Q. How is NIC calculated on wages?
As mentioned above, for employers and employees (but not directors) the amount of Class 1 NIC payable is based on the ‘earnings period’ rather than the tax year. This means that for monthly paid employees the amount of NIC payable each month is based on that month’s earnings. The result of this is that where an employee’s pay is variable, rather than averaging out the NIC payable over the tax year (as happens with income tax), each month is looked at in isolation. This can mean that if a bonus is received one month that pushes an employee’s pay over the Upper Earnings Limit that month their liability reduces to 2% on the proportion above the limit, even though across the tax year their earnings may not exceed the annual equivalent. Since the self-employed pay NIC based on annual profits this means that self-employed people with ‘lumpy’ earnings could pay more than an employed individual with ‘lumpy’ earnings, though NI rates for the self-employed are lower so you could argue it’s ‘swings and roundabouts’.
Q. And you pay less if you are self-employed?
Yes, as indicated above, annual earnings of self-employed workers between £9,568 and £50,270 are taxed at 9% for NICs while the employee on an equivalent regular wage is taxed at 12% for NICs. In 2017 then Chancellor Philip Hammond tried to close the gap with an NI rise for the self-employed but performed a U-turn after facing criticism that this would amount to breaking a manifesto pledge.
Those who defend a lower rate for the self-employed generally argue that it reflects a lower entitlement to state benefits for the self-employed, however this differential has reduced in recent years. IFS look at the arguments on pages 38-39 of this note. They conclude that “the difference in entitlements is far too small to justify the current tax advantages.”
Q. Didn’t Rishi Sunak say something about this a while back?
Yes. Announcing the Self-Employment Income Support Scheme in March 2020, Rishi Sunak told MPs: "It is now much harder to justify the inconsistent contributions between people of different employment statuses. If we all want to benefit equally from state support, we must all pay in equally in future." Interviewed by The Sun during last year’s party conference Sunak stood by this point, saying “the way that we have treated the self-employed has been comparable to how we've treated those who are employed” and “[t]hat is something that we should all reflect on because there is a difference currently in the [tax] system.”
It’s worth noting that the 3% difference between NI rates paid by the employed and self-employed is dwarfed by the 13.8% cost of employers’ NICs, levied on wages paid to employees but not on payments made to independent contractors. Avoidance of employer NICs is one of the main drivers of misclassification of individuals as self-employed rather than employed (i.e. false self-employment). Those affected miss out on employment rights such as national minimum wage, holiday pay and sick pay. Any increase in the rate of employer NICs is likely to exacerbate this problem.
Q. Can you reduce your NI bill by incorporating?
Yes. The NIC system is sometimes manipulated by incorporating a business and trading through a company instead of being self-employed. Company directors can minimise their tax burden by paying themselves (as the sole ‘employee’) a wage up to the primary threshold at which employee and employer NICs become liable. As this threshold is below the personal allowance, it also incurs no income tax. This wage can then be deducted from the company’s gross profits, the remainder of which are liable to corporation tax. Post corporation tax profits can then be withdrawn as dividend income for the sole shareholder (the director), with no NICs payable. Dividends are also liable for income tax at lower rates than other types of income and have their own tax-free allowance. Directors can also benefit by retaining profits within the company, paying capital gains tax upon selling it.
The company structure can also be useful for couples as it potentially allows both couples to receive a ‘salary’ free of NICs but with NIC credits from the business (so long as both do some work for the company), so as to potentially provide full state pension entitlement for an otherwise ‘non-working’ partner.
There are, of course, lots of pros-and-cons of trading through a company and an individual’s NIC liability (and qualification for contributory benefits) is just one of many considerations. People incorporate (or not) for a range of reasons, not just tax and NICs, and it would not be fair to categorise those who are influenced by tax as tax avoiders - they are effectively choosing one lot of statutory rules rather than another where the state has left them free to choose, without anything covert or artificial about it.
Q. Is NI avoidance a big problem?
Generally no, as most loopholes have been closed over the years. For example, those working through their Personal Service Companies are subject to IR35 rules (and now the Off-Payroll Working rules) which impose an employment status test to prevent income tax and NICs on ‘earnings’ being avoided by imposing a company structure to treat what would otherwise be earnings as company profits. Similarly, while NIC avoidance is already within the scope of the Disclosure of Tax Avoidance Schemes (DOTAS) regime, new measures in the NICs Bill currently going through Parliament will strengthen HMRC’s ability to clamp down on the market for NIC avoidance and hopefully mean that HMRC will be able to act quickly and decisively where promoters fail to provide information on their NIC avoidance schemes.
But abuses do still exist.
A current common example is the use of mini umbrella companies (MUCs) that have a few employees, against which the umbrella company employer can claim the ‘employment allowance’. Typically, an employment agency’s temporary labour is moved away from their payroll (where only one annual amount of the employment allowance could be claimed) into MUCs each of which (artificially or otherwise) appears to satisfy the qualifying conditions to claim the employment allowance. This means each MUC ‘employer’ can reduce their annual NIC liability by up to £4,000 per annum. We understand HMRC has been aware of such schemes operating in the temporary labour sector for some considerable time and while we are assured action is being taken there is very little public evidence to suggest that HMRC are concertedly tackling such schemes.
Q. Do other countries levy National Insurance equivalents?
Yes. For example, each EU country has its own social security laws and levy their own form of National Insurance (social security). There are, however, big differences in the way different EU countries have organised who pays (and what they pay) and which benefits, healthcare and other social security services the contributions fund. For example, in Germany social security contributions are primarily financed though employee and employer contributions. These can total up to about 40% of wages (with as roughly 50:50 split between employee and employer contribution) but are subject to a wage cap. These contributions fund health, long-term care, pension, unemployment and occupational accident insurance entitlement.
Social security contributions are also levied in non-EU countries. For example, in the USA social security is payable (with some exceptions) by employees (and their employers) and the self-employed. Broadly speaking, these contributions fund benefits for retired individuals, disabled persons and dependants.
It is worth noting that, subject to a few exceptions for working temporarily abroad, the obligations and rights under each country’s laws are the same for all workers in that country, whether those workers are local or from abroad. Also, the UK’s social security rates are relatively low compared with most of Europe. Equally the UK’s maximum pension amount is also relatively low compared to Europe. Child benefits are on the higher side of average in the UK compared to mainland Europe. Similarly with maternity benefits.
International double social security agreements try to limit the extent to which migrant and expatriate workers are ‘in and out’ of different social security systems and try to avoid them having to make double contributions.
This explainer was written by:
Matthew Brown, Technical Officer (Employment Taxes), Chartered Institute of Taxation
George Crozier, Head of External Relations, Chartered Institute of Taxation
With additional content from John Cullinane, CIOT Director of Public Policy