When you’re employed, your income tax and National Insurance Contributions (NICs) are deducted at source through the PAYE (Pay As You Earn) system so that you receive a salary net of tax and NICs each month. When you become self-employed you will move out of this system, and your tax and NICs are calculated annually, based on your Self Assessment Tax Return. However, rather than paying your tax/NICs just once a year after the Tax Return has been submitted, the government has a system to smooth this out, known as “Payments on Account”.
As a self-employed person, you will automatically be required to make Payments on Account for a tax year unless the tax you owed for the previous year was less than £1,000 or if more than 80% of your personal tax liability was deducted at source, for example through PAYE.
How does it work?
Let’s say you’ve just completed the first tax year of being self-employed and your Self Assessment Tax Return (SATR) calculates that you must pay £8,000 of tax/NICs. We’ll refer to this mixture of tax and National Insurance Contributions (NICs) as “tax”, for simplicity. The tax year runs until 5th April and this calculation covers the 2022/23 tax year. The actual payment of this tax is due by the SATR deadline of midnight on 31st January the following year. This means you must pay your 2022/23 tax liability by 31st January 2024.
At first, this looks like an advantage over the tax payments that were taken from your monthly salary under the PAYE system when you were employed. You don’t have to pay any tax for over nine months! However, this also means the government gets your tax a long time after you earned the income. To balance this out, the government will demand half of the following year’s tax at the same time as the previous year’s tax, with the other half due by 31st July.
The result of this is that, on 31st January 2024, you will pay all of the tax that you owe for 2022/2023 and half of what you owe for 2023/2024. This doesn’t look quite so appealing as you will have to pay some tax in advance.
How do you know how much tax you owe for a year that’s only halfway through?
HMRC assumes you’ll incur as much tax/NICs as you did the previous year and, if it turns out that this is insufficient, then you make a balancing payment the following January.
In our example, let’s say the assumption is correct and you owe another £8,000 for the 2023/24 tax year and the same again in 2024/2025.
Your payments will look like this:
- 31st January 2024: £12,000 = £8,000 tax for 2022/23 and half of the £8,000 tax due for 2023/24
- 31st July 2024: £4,000 = this is the other half that is due for 2023/24
- 31st January 2025: £4,000 = half that is due for 2024/25
- 31st July 2025: £4,000 = the other half that is due for 2024/25
As you can see, the payment due on 31st January 2024 is particularly high since you are paying the entire tax liability for 2022/23 at the same time as the first Payment on Account for 2023/24. It is therefore important to budget for this. After that, the tax is paid in two equal instalments each year.
However, your income – and therefore your income tax and NICs – is likely to change from year to year. This means that a Balancing Payment may be required on 31st January after your Tax Return has been filed. If your tax is higher than the previous year, you’ll have to pay extra to cover the balance of the liability.
- In our example, let’s say it turns out that your tax for 2023/2024 is actually £8,500. Then the 31st January 2025 payment will be £4,750 rather than £4,000. The amount of £4,750 is made up of the extra £500 due for 2023/24, together with a higher Payment on Account for 2024/25, since this Payment on Account is now based on the 2023/24 figure of £8,500.
Conversely, if your tax bill turns out to be lower than it was in the previous year, then you will have less to pay by 31st January following the end of the tax year.
If you know that your profits will be lower than in the previous year then you can make a claim to reduce your Payments on Account before they fall due. This can be a tricky calculation and, if you underpay, then HMRC will charge you interest from the original due dates of the Payments on Account. When doing your calculations, don’t forget that the Payment on Account system also covers Class 4 National Insurance Contributions and not just income tax.
If this sounds complicated and you’d like some help, then give us a call on 01491 578207. At Kench & Co Ltd we have over forty years’ experience of dealing with tax. We know that it’s daunting to deal with HMRC and that managing cash flow is at the heart of the challenges small business owners face every day. You want to know what you have to pay out and when. To make sure you can focus on making a success of your business, let us give you a hand with your tax obligations.
With lots of HMRC deadlines to remember, it’s easy to forget to make Payments on Account, or not to get to grips with when and why they are due. For more information on how we can help you, visit our website at www.kench.co.uk or give us a call to speak to one of our experienced team.