15th July 2021
When you begin working as a freelancer via a limited company or a sole trader, one fundamental change is the way you pay tax.
Under the Pay As You Earn (PAYE) system, your employer deducts and hands over the necessary taxes and social security to HMRC on your behalf. As a company director or a sole trader (unless you work via the CIS system), you will be liable for all of your taxes and NI in the subsequent January following the end of the current tax year on 5th April. Directors may have a little PAYE withheld depending on where they set their salary, but again, they will pay the majority of further taxes in January.
Most people are aware of the big January deadline. Something not many people are prepared for, however, is Payments on Account.
If you meet specific criteria, in addition to the tax you owe, HMRC will ask for pre-payments of tax for the following tax year. These payments are calculated based on your previous year’s tax bill and are due in two instalments.
HMRC would like you to think of this exercise as paying off some of your tax in advance and stopping you from getting too much in arrears when in reality, it is just the Exchequer wanting their readies sooner!
Who has to make Payments on Account?
You will be asked to make two payments on account every year unless:
- Your Self Assessment tax liability was less than £1,000
- You’ve already paid more than 80% of the total tax you owe
How do Payments on Account work?
Each pre-payment is 50% of your previous tax liability. The instalments are due in January and July, respectively.
For example, let’s say 2020/21 is your first year trading. In April 2021, we calculate that you owe £5,000 – due 31st January 2021.
In addition to this you will also pay:
£2,500 (50% of £5,000): also 31st January 2022
£2,500 (the remaining 50% of £5,000): 31st July 2022
Total due 31st January 2021: £7,500 (£5,000+£2,500)
Total due 31st July 2021: £7,500
Let us say things have gone well in your second year, and we calculate your tax as £7,500.
By 31st January 2023, you will be paying £2,500 (£7,500 less the pre-payments of £2,500 x two you have already made).
You will still need to make payments on account, calculated on the original tax owing of £7,500.
In addition to this you will also pay:
£3,750 (50% of £7,500): also 31st January 2023
£3,750 (the remaining 50% of £7,500): 31st July 2023
Total due 31st January 2023: £6,250 (£2,500+£3,250)
Total due 31st July 2023: £3,250
This process continues each year until you no longer meet the Payment on Account criteria. This is usually due to moving to a PAYE role or leaving the UK. Payments on account do not include anything you owe for capital gains or student loans (if you’re self-employed) – you’ll pay those in your ‘balancing payment’.
Adjusting your Payments on Account
As the payments on account are based on your previous tax bill, HMRC assume you will have roughly the same amount of income and, as such, owe a similar amount of tax in the following year.
Given the inherent fluctuation in working for yourself, this is not always the case. At which point, if you know your taxable profits or dividend income will be less in the following year, the payments can be adjusted to a lower level to reflect your reduced income.
Going into a full-time PAYE will also mean your tax going forward will be fully deducted at source, and there is further scope to amend the pre-payments.
Adjusting the payments negligently can lead to HMRC reinstating them in full and charging interest and possibly penalties. Definitely check with one of our team before going ahead with this.
Let MyAccountant help relieve the stress.
We hope that the above has helped answer your questions about Payments on Account.
If you’d like us to help you with your tax return, don’t hesitate to contact our tax manager Robert Trappe. If you are a client of ours, we are likely to have half of the information required to complete your tax return already.