Payments on account.
One of the most common questions I get, is about the payment on account. Mainly “what are they” usually followed by “why?” As one client put it, “It sounds a lot like an interest free loan to HMRC”. Make of that what you will…
In a nutshell, payments on account are advanced payments towards the following tax year, based on your income tax & class 4 NI contributions in the current tax year.
For example, say you have a trade profit of £25,000 and it is year 1 of your freelance work, the tax due would look something like: -
Income tax due £2,486.00
Class 4 NI due £1,273.85
Total due £3,759.85
It is worth noting that in the 22/23 tax year, there would be class 2 NI as well, but that has basically been abolished so let’s ignore it for now.
Your total tax liability for he period ending 5 April 2023 is £3,759.85. BUT they want you to pay that amount again, towards next year. They do this by asking you to pay 50% in January, and 50% in July. So a further £1,879.92 in January and £1,879.92 in July. This means that your tax payments are as follows: -
Due by 31 January £3,759.85 + £1,879.92 = £5,639.77
Due by 31 July £1,879.92.
In year 1 of payments on account, especially when it is something that you didn’t know about (which a lot don’t) this can feel like a much inflated tax payment, based on the earnings that you have made in the year. However, in years 2 and 3, you will start to see why they are there.
If your year 2 profit is exactly the same as your year 1 profit, and assuming the tax thresholds have stayed the same, you will have the same tax liability. £3,759.85. The difference is, you have already paid that amount. So all you will have to pay are the payments on account. So rather than a January payment of £5,639.77, you will only have to pay the £1,879.92. This is now just half of your tax liability, so when your income plateaus to a certain level, you will find that your tax bill is nicely split in two equal instalments throughout the year.
If you make more profit than the previous year, you will have a balancing payment in January. The differing in the income tax and C4 NI due, vs already paid. If you have made less profit, you will more than likely be in credit. So you can see how it works.
Reducing my payment on account – should I do it?
I often get asked this question as well. Firstly, I sometimes get “I don’t want to pay my payments on account, can you remove them” unfortunately, they are mandatory. You can, however, reduce them or remove them if you believe that your profits will be sufficiently reduced, so that you have a much less, or no tax liability at all in the following year. A good example of removing payments on account totally is if you go back to PAYE employment at the start of a tax year, so you know without a doubt you will have no tax liability in the following year that isn’t covered by your PAYE deductions.
If you are going to have a much reduced profit in the following tax year, for instance if you know you are going to spend 9 months of the year on Maternity Leave, and be earning HMRC’s wildly generous £172.48 per week Maternity Allowance, you may reduce your payments on account, in line with what you think your tax liability will be in the following year.
Warning!! Doing this incorrectly will result in late payment interest. For example, if you are going on maternity leave, or taking an extended period of time off work, and you think your taxable income will only yield a tax and C4 NI liability of £1,000 for the year, you can reduce your payments on account to £500 each. IF you end up earning more than you thought, and your tax liability was for example £2,000, HMRC would retrospectively change your payments on account to £1,000 each, and charge interest on the fact that you haven’t paid that yet. So you may fund that as soon as you file your return, HMRC start to demand that the payments on account are paid. This situation only occurs if you reduce your payments on account, not if you have just earned more in the following year.
I hope that you have found this helpful. Of course, please do not hesitate to get in touch if you have any questions.
All the best!
Andy
andy@interpretingtax.com