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 2020/2021, which finished on 5 April 2021. The tax for this year is due by 31 January 2022
- The next tax year, 2021/2022, will finish on 5 April 2022; which is just over two months after the tax for the previous year is paid
- You would pay half of this tax bill on 31 January 2022 (10 months into the current tax year) and the other half on 31 July 2022 (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 2020/2021.
He has no other income.
He prepares his accounts and submits his tax return for the tax year 2020/2021; this covers the period 06/04/20 to 05/04/21.
The personal allowance (amount you can earn before you start to pay income tax) for the tax year 2020 / 2021 is £12,500.
His tax bill for the year (excluding his Class 2 NICs which are not included in the Payments on Account calculation) 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 £9,501= amount subject to Class 4 NICs at 9%
£25,500 minus £9,501= £15,999 x 9% = £1,439.91 Class 4 NICs due
Total taxes due and payable by 31 January 2022 = £4,039.91 for the tax year 2020 / 2021 plus Class 2 National Insurance.
1st Payment on account for 2021 / 2022 due on 31st January 2022 = 50% of previous tax bill = £2,019.95
The total due payable on 31st January 2022 is £6,059.86
2nd Payment on account for 2021 / 2022 due on 31st July 2022 = 50% of previous tax bill = £2,019.96
By 31st July 2022 payments of £4,039.91 would have been made towards the tax due for the tax year 2021 / 2022 which would have ended on 5th April 2022.
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 (e.g. 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 (i.e. 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.