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Payments on account for the self-employed – What are they and do I have to pay them?

10/12/2018

Submitting your self-assessment tax return, simply put, is a pain in the butt. The mad rush at year-end to collate all of your invoices, the painstaking research going through exactly what expenses are claimable and which ones aren’t, and then realising that you have a whopping great tax bill to cover. However, if this is the first year of you submitting your self-assessment, or if this is the first year that your income tax bill is over £1,000, then you may not be aware that you may also have to fork out for something known as a ‘payment on account’.

So what exactly is a payment on account?

A payment on account in layman’s terms is a contribution towards your next year’s tax liability. And by contribution, what I actually mean is that over the year you will end up paying for your following year’s tax liability in two lump sum payments. The first being on the 31st of January, and the second on the 31st July. Now the 31st July payment isn’t going to necessarily be an issue, because you will already know about it, however the really bad news is the fact that your payment on the 31st January is also the date that your actual income tax liability is going to be due, meaning that your bill is potentially going to be a lot higher than you first thought… 50% higher.

Let me give you a working example to hopefully try and explain this a little better

In the tax year 17/18, Liz worked as a freelance brassiere designer. She invoices her client each month for £3,000 and also bills them back for materials that she has purchased to provide physical examples of her designs for approximately £500 per month. The total turnover in this example is £3,500 per month and this is the figure that will need to be included on her tax return as in the example below.

Liz then deducts the £500 per month for materials, her travel expenses, the cost of her mobile phone, the proportion of her utilities deductible whilst working at home, and any other expenses that she is eligible to claim for. Her expenses need to be deducted against the income figure and these are entered onto the tax return as exampled below.

After the allowable expenses have been deducted the net profit of Liz’s business is a very healthy £30,990. Now, as a citizen and taxpayer of the UK, Liz is entitled to a personal earnings allowance. Liz has the standard tax code of 1150L which means that she can earn £11,500 for the fiscal year ending 2018 before any income tax is due. With this taken into account, Liz will need to pay 20% income tax on £19,490 (her net profit) which equals £3,898. As most of us know there are other income tax bandings, however, for the sake of ease in this example, I have just focused on the basic rate.

Once the income tax is worked out, we then need to calculate the National Insurance (NI). There are actually two different types of NI that Liz needs to account for as being self-employed, Class 2 and Class 4. These are calculated slightly differently than income tax, so I have discussed each separately to try and further help you along they way.

Class 2 NI

Liz needs to make Class 2 NI payments for state benefits like her state pension, this is a fixed payment of £2.85 per week (£148.20 per year).

Class 4 NI

Class 4 NI is a tax paid to the Exchequer towards civil services like the NHS, highway maintenance etc. Class 4 NI for the year ending 2018 was worked out on earnings over an allowance of £8,164 at 9%. For Liz, this means that she will pay 9% on her earnings over £22,826. This equals £2054.34 that Liz needs to pay in Class 4 NI.

Liz’s total income tax and NI bill

So, accounting for all her taxes, Liz has a total income tax bill of £6,100.54. This is shown below with a snapshot of a Liz’s tax computation as a working example.

How Liz’s payments on account work

As Liz’s income tax liability is over £1,000, she will have to make ‘payments on account’. As mentioned earlier these are split into two payments, the first on the 31st January, along with the £6,100.54 income tax, and the 2nd on the 31st July. Now here is the scary bit, Liz’s first payment on account is going to be £2,976.17, meaning that she needs to find £9,076.71 by the 31st January and then another £2,976.17 on 31st July. For a working example please see below;

Now fortunately for Liz, she has been with ShoeBox.co.uk since day one, so her accountant had already discussed these payments on account with her, so Liz was able to prepare for the upcoming payments. However, many people who register as self-employed without first discussing this with an account can find this to be a real shocker unless they have done their own research.

What to do if you cannot afford both your first year’s tax liability and your payment on account

This depends on your future earnings. If your future earnings are going to be significantly less than your first year, or you were only working self-employed for a short time then you can actually give HMRC a call and discuss with them that the ‘payments on account’ do not accurately reflect your future earnings and they will make a decision to remove your payments on account. I strongly advise only doing this if you are certain that your future earnings are going to be significantly less, because if you are wrong then HMRC will actually charge you the interest that they will lose from holding the money and also apply a monetary penalty for not taking reasonable care.

If however you are going to continue earning the same, or more from self-employment then the payments on account will stand. In this scenario, we have a couple of suggestions on what to do if you cannot afford the payments.

Setting up a payment plan with HMRC.

From experience, HMRC does not always take kindly to asking for payment plans as they will not earn the interest as discussed with removing your payment on account. In our opinion, the best thing to do if you cannot afford both your tax bill and your first payment on account is to either take a traditional bank loan or to use a revolving credit line.

Using a bank loan or a revolving credit line to cover the payment

With a typical bank loan, you have both a term to pay back the loan of XX years and an interest charged on an annual basis; APR. This we would probably advise avoiding as you will be paying for your tax bill over a number of years, so it will potentially damage your future growth prospects and also cost a fortune in interest.

The other option is a revolving credit line.

With a revolving credit-line you typically have a monthly interest rather than an APR. The interest is monthly as it is pro-rated daily so if you pay it back within a week, you only pay a weeks’ worth of interest. The reason that we prefer this is because you can pay the loan down much sooner and reduce the overall amount of interest that you pay.

Credit to our sister company ShoeBox.co.uk for the blog post.