Going freelance, starting up your own business or being your own boss means keeping a close eye on finances to make sure things are going well enough for you to be able to take some money out of the business to live on.
However, not everything that you invoice and collect from your clients or customers, less your costs, belongs to you.
Not all of it is your money
Except in the case of low earners, you’ll owe some of it to the “tax man”, AKA HMRC.
Knowing roughly what you owe to HMRC so that you can put this aside into your TAX POT is really key to avoid getting yourself in a muddle, spending more than you should and receiving an unexpected tax bill when your accounts and tax returns are filed that you just don’t have the funds to cover.
Income less Costs = Profit
Income, also known as turnover or billings, is the amount that you charge your customers or clients.
If you’re VAT registered the income recorded in your accounts is excluding VAT as the amount of VAT charged is not your money. You’ve just collected that on behalf of HMRC and have to pay it over to them, less any VAT that you may have paid on allowable business costs.
Of course, that’s not the end of the story in terms of deriving your profit as you may have incurred some (allowable) costs in generating that income such as travel expenses to visit a client or software that you need to provide your services.
The key is making sure that you record just allowable costs.
FreeAgent have a great guide on this – The A-Z of small business expenses & costs
THE TAX POT
From your profit you’ll have to pay some tax and you should budget for this as you go setting aside a bit of the profit into THE TAX POT.
The best way to do this is to set up a separate bank account.
If you are self employed / sole trader then this can be a personal savings account.
If you run a Limited Company then THE TAX POT should be kept in the Limited Company and not withdrawn. So you’ll need to open a business banking savings account in the name of the company.
You may not earn much in the way of interest on THE TAX POT Savings Account and you will need to apply discipline to ring fence the amount ensuring that you don’t dib into it if funds are tight.
Apply the discipline of “It’s THE TAX POT and not my money”!
How much you need to put into THE TAX POT depends on the structure that you operate your business under.
Caution – do remember that between the end of the tax year and the following 31st January you will have funds in THE TAX POT related to the previous year.
The Tax Year 2019 / 2020 runs from 6th April 2019 to 5th April 2020.
The tax for that year is due by 31st January 2021.
At the end of August 2020 you should have the whole of the tax for 2019 / 2020 in THE TAX POT as well as the tax for the first five months for the 2020 / 2021 tax year.
Tax Pot Rule of Thumb Sole Trader
Much the simplest way of operating, a sole trader needs to set aside funds for Income Tax as well as Class 2 and Class 4 National Insurance.
If you want a precise figure to allocate to THE TAX POT then use something like The Tax Calculator for the Employed and Self Employed.
For a more precise amount to set aside on a regular basis then refer to something like the HMRC Self Assessment Ready Reckoner where you enter your estimated weekly or monthly profit.
Tax Pot Rule of Thumb Limited Company
For those operating through a Limited Company THE TAX POT is twofold:
The Company TAX POT
The company pays corporation tax on profits where:
Income less allowable costs = company profit The current rate of corporation tax is 19% So profit x 19% = THE COMPANY TAX POT
Your personal TAX POT
The amount left after taking off the corporation tax (distributable profits) is what you can take out of the company in dividends. That means that after corporation tax, at 19%, 81% of profits are distributable as dividends although you don’t have to distribute all of the available profits as dividends and you will only pay income tax on dividends that have been distributed. This can get confusing and it is an area where many business owners operating through a limited company will use an accountant.
Income tax may need to be paid on dividends. A general rule of thumb for tax on dividends is:
- First £2,000 of dividends – tax free
- 7.5 % for dividends falling within basic rate tax
- 32.5% for dividends falling within higher rate tax
- 38.1% for dividends falling within the additional rate of tax with income over £100,000 meaning restrictions on your personal allowance
The amount falling within the relevant tax bands needs to be worked out along with any other income but the above can be used as a guide, especially for those falling within the basic rate tax band.
If all that sounds complicated then use one of the many online dividend calculators such as the one on the Which web site.
Caution – if you have drawn a salary from your limited company this needs to be include in your personal TAX POT workings. The salary will of course be an allowable expense for arriving at the company’s profit figure.
Simply put, this is what you can take out of the business after allowing for any taxes due that need to be built up in THE TAX POT.
Key TAX POT Takeaways
- Run your business well by having a handle on your finances as you go
- Set up a separate TAX POT bank account
- Work out how much you need to put into your TAX POT at least once a month
- Don’t touch your TAX POT until you need to pay your tax bill – it isn’t your money