If you work for yourself you will definitely know about self-assessment tax returns and having to pay your annual tax liability, and they are probably the bane of your life when the time comes around to deal with them each year.
Payments on account were created to help people who are self-employed manage their tax payments, but it is also one of the most misunderstood aspects of the whole self-assessment process.
What are Payments on Account?
Payments on account were designed to help individuals spread their tax payment. As their name suggests, they are payments towards the following year’s tax liabilities. Payments on account are mandatory if your annual tax liability is above £1,000.00 and less than 80% of your tax is deducted at source.
The payments are calculated by using your tax bill from the previous year and then splitting this into two instalments. The first instalment is paid on the 31st January following the end of the tax year at the same time as your balancing payment; the next is paid six months later on 31st July.
The payments on account also include your Class 4 National Insurance contributions. However, they do not include any Class 2 National Insurance contributions, student loans or capital gains tax – if you owe any of these taxes, then they must be paid as part of your balancing payment.
Example
Derek has an income tax liability of £1,648.20 for the year ended 5th April 2018. This includes £148.20 of Class 2 National Insurance contributions. Derek’s payments for the next twelve months will be:
| Due by 31st January 2019 | ||
| Balancing payment for 2017/2018: | £1,648.20 | |
| First payment on account towards 2018/2019: | £750.00 | |
| Total amount due: | £2,398.20 | |
| Due by 31st July 2019 | ||
| Second payment on account towards 2018/2019: | £750.00 |
Overpayments and Underpayments
It is very rare for the payments on account to match the following year’s tax liability. You will find that your annual liability will be either higher or lower, depending on how your business has performed compared to the previous year.
If you do make an overpayment, HMRC will refund you the money which was overpaid. On the other hand, if your payments on account are less than your annual tax liability, you will need to make a balancing payment by 31st January after the end of the tax year.
Example
Derek’s business performs better in the year ended 5th April 2019. His overall tax liability is £2,153.40, of which £153.40 is Class 2 National Insurance contributions.
Derek has already made payments on account of £1,500.00. This means he is due to make a balancing payment of £653.40 by 31st January 2020. And as his liability continues to be over £1,000.00, he will continue to make payments on account towards the 2019/2020 tax payment.
| Due by 31st January 2020 | ||
| Balancing payment for 2018/2019: | £653.40 | |
| First payment on account towards 2019/2020: | £1,000.00 | |
| Total amount due: | £1,653.40 | |
| Due by 31st July 2020 | ||
| Second payment on account towards 2019/2020: | £1,000.00 |
Reducing Payments
Incomes fluctuate and HMRC are aware of this, so the option to reduce your payments is available to you. If you know your tax bill will be lower in the following year, you can request HMRC to lower your payments on account.
This can be done by making a claim on your tax return or applying via your online account. Just remember that if you reduce your payments on account too much, HMRC will charge interest on the underpaid amount.
Payments on account are a necessary evil, however, they do allow you to split your tax liability across two separate payments. With careful planning, the dramatic effects when you first enter the payments on account system can be minimised to a degree.
We’re here to help with your sole trade or partnership accounts and tax returns, and we also offer tax planning as part of our service to you. If you would like any further information or would like a free one-hour consultation, then please get in touch via our contact page.