Many self-employed people (AKA sole traders) who complete a Self-Assessment tax return for the first time are left somewhat baffled when their tax bill is much bigger than expected.
It happens because after they file their first Self-Assessment tax return, they find out they need to make a “payment on account”. But, what are payments on account and what key things should you know about them?
1 HMRC uses the payments on account system to ensure that it collects at least some of the tax you owe in the current tax year.
2 Payments on account are based on earnings in the previous tax year. They can make it easier to pay your tax bill at the end of the current year.
3 When you complete your Self-Assessment tax return for the previous year, you’re nearly at the end of the current tax year. So, you’re not really paying tax in advance at all.
- Take the tax year 2019/2020, which finishes on 5 April 2020 and the tax is due by 31 January 2021.
- The next tax year, 2020/2021, finishes on 5 April 2021; just over two months after the tax for the previous year is paid.
- You would pay half of this tax bill on 31 January 2021 (10 months into the current tax year) and the other half on 31 July 2021 (four months after the end of the tax year). So, you’re not paying anything in advance compared to the Pay As You Earn scheme, which taxes employees’ income earned each week or month.
HOW DOES IT WORK?
Jake makes £25,500 profit from his small business in the tax year 2019/2020. He has no other income. He prepares his accounts and submits his tax return for the tax year 2019/2020; this covers the period 06/04/19 to 05/04/20.
The personal allowance (amount you can earn before you start to pay income tax) for the tax year 2019 / 2020 is £12,500.
His tax bill for the year (excluding his Class 2 NICs) will be:
Profit minus personal allowance = taxable income
£25,500 minus £12,500 = £13,000 taxed at 20% = £2,600 income tax due
Profit minus £8,632 = amount subject to Class 4 NICs at 9%
£25,500 minus £8,632 = £16,868 x 9% = £1,518.12 Class 4 NICs due
Total taxes due and payable by 31 January 2021 = £4,118.12 for the tax year 2019 / 2020
1st Payment on account for 2020 / 2021 due on 31st January 2021 = 50% of previous tax bill = £2,059.06
The total due payable on 31st January 2021 is £6,177.18
2nd Payment on account for 2020 / 2021 due on 31st July 2021 = 50% of previous tax bill = £2,059.06
By 31st July 2021 payments of £4,118.12 would have been made towards the tax due for the tax year 2020 / 2021 which ended on 5th April 2021.
4 If you’re self-employed, your payments on account will include your Class 4 National Insurance contributions (NICs).
5 If your tax bill for the year for which you’re completing the Self-Assessment is more than £1,000, you’ll have to make a payment on account towards the current tax year. However, if more than 80% of your income is taxed at source (eg if you’re a subcontractor working under the Construction Industry Scheme), you won’t.
6 Payments on account must be made in two instalments: before midnight on 31 January in the current tax year and before midnight on 31 July.
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Because payments on account must be made in two instalments, effectively, it means that in your first year you’ll need to fork out 1.5 times your tax bill on 31 January, which is fine if you’ve been budgeting for it as you go. To avoid tax bills that you can’t afford to pay, make sure that you set aside enough of your earnings as you go. In second and subsequent years your payments on account are deducted from your tax bill leaving a balancing charge (additional tax to pay) or a refund if you’ve paid too much.
7 If you still owe tax after you’ve made your payments on account, you must make a “balancing payment” by midnight on 31 January in the next year.
8 Payments on account won’t include amounts you owe for capital gains tax or student loans (if you’re self-employed). You pay for these in your balancing payment.
9 If you’ve ceased trading or your profits are falling, you can request a reduction in your payments on account, using the Self-Assessment form, although it may not allow you to reduce payments on account to nil. Alternatively, you can use the HMRC form specifically for this purpose (ie the SA303 form).
10 If your payment on account means you pay too much, because your actual tax bill turns out to be lower, HMRC will send you a refund. If you reduce your payments on account and underpay tax, you’ll be charged interest.
- FURTHER READING >> Ten Tips for your Self-Employed Self-Assessment