Each year as Self Assessment Tax Returns are prepared and tax calculations made gasps of “HOW MUCH” can be heard around the country.
Why is your tax bill a shock?
It never ceases to amaze me that many self employed are shocked by their tax bill with little understanding of how much profit (income less costs) they’ve made in the year.
Understanding your finances and accounts is an essential life skill that should be taught in schools along with the appreciation of why we have to pay taxes, what they are used for, how they are collected and what happens if you don’t pay the right amount.
Unfortunately these skills are not taught in school but that doesn’t absolve you of the responsibility of learning them with the first lesson being …..
It’s not your money
When you make money from your self employed business you have to put some of it aside for tax. Not everything that drops into your pocket or bank account is yours. Part of it belongs to the tax man.
The best way to approach your business finances is to adopt the mentality that the profit after allowing for tax is what you can take from the business; that is what belongs to you.
Looking at things another way, if you spend too much and haven’t set aside any money to be able to meet your tax bill at the end of the year then you are effectively taking an unauthorised loan from Tax Payers without their consent!
Do you want the street lights to switch on at night?
“Nothing is certain but death and taxes” – a phrase attributed to multiple authors including Benjamin Franklin. Whoever said it they were certainly correct.
The taxes raised pay for the Public Services that we need and consume – road, health service, Police, Ambulances, Education to name but a few. If as a Nation we want Public Services then we need to fund these by way of a system of taxation. Tax is a social contribution.
That’s just how it is. Once you accept that as a concept then the only issue remaining is making sure that you pay the right amount of tax.
All too often it’s thought that accountants will work some miracle and reduce a tax bill by huge amounts. If that were possible then most accountants would start by doing that for themselves!
Put simply, the role of an accountant is to make sure that you follow the rules and regulations in place, record the appropriate costs in your accounts and pay the right amount of tax based upon your income, profit and circumstances.
Make sure your Tax Pot is not Potless
As you earn your money the best thing to do is to create a separate “Tax Pot” whether as a separate account or just a ring fenced amount in your business current account that you know not to touch.
By saving for tax as you go you will have enough set aside for your year end tax bill and won’t be worried when your self assessment submission spits out the tax calculation after you’ve entered all of your numbers.
Tax Budgeting Rule of Thumb
The amount that you need to put aside for tax depends on if you are a self employed sole trader or operating your business through a limited company.
For budgeting purposes the following is a good guide for setting aside money into your Tax Pot:
Self Employed Sole Trader
Set aside about 25% of profit if you’re a standard rate tax payer. This takes into account any Class 4 National Insurance.
If you’re a higher rate tax payer increase this to around 35%.
The percentage is for budgeting only and the actual tax due will differ once you’ve completed and filed your self assessment.
Director of a limited company
On any dividends taken from the company set aside:
7.5% of dividends taken if a standard rate tax payer increasing it to 32.5% of dividends for amounts over £50k and then 38.1% of dividends for amounts over £150k
You may of course need to budget for further tax if you have other income such as a salary or property rental income,
Payments on Account
Many seem to think that Payments On Account are an outrageous liberty when in fact they’re not.
When you make the first payment on account by 31st January you are already 10 months into the current tax year. On that date you’ll pay only half of the estimated tax bill for the current year which you should have already set aside in your “Tax Pot”. The estimated tax for the rest of the tax year isn’t due until 31st July.
So you’re not paying in advance. You’re paying what you owe in arrears from your tax pot that you’ve already set aside – saving the tax as you earn. Click to read more about Payments on Account.