When you start working for yourself as a sole trader, one of the initial benefits is that you don’t have to pay tax as money comes in – unlike the PAYE system, in which employees’ earnings have tax deducted at source.
As a self-employed worker, your first tax bill is likely to be due on the 31st January that falls after the end of your first financial year (which runs until 5th April).
So if you started as a sole trader in, say, November 2015, you wouldn’t have to pay tax until the Self Assessment deadline for 2015/16, which is January 31 2017.
First bill shock
That’s the good news. The bad news is that HMRC runs a system called “payment on account” for those who pay most of their tax through Self Assessment.
This means that, in addition to the 2015/16 bill that you need to settle by midnight on 31st January, you also need to pay half of your total expected 2016/17 tax by the same deadline. The other half of the 2016/17 bill is then due on 31st July.
This way, HMRC ensures that self-employed workers aren’t benefiting by being able to pay considerable amounts of tax many months in arrears.
The result for many newly self-employed people is that they typically face a tax bill which is roughly 50% higher than they had been expecting.
Payment on account is not something that is widely known about among people who have never been part of the Self Assessment system. And if you’ve been expecting a tax bill of, say, £10,000 having to find an extra £5,000 to cover your first payment on account may simply be impossible.
If you can’t pay the whole tax bill by 31st January, however, you are likely to face interest charges on the outstanding amount.
Adjusting the payment
The size of the payment on account is based on your tax bill for the previous financial year. HMRC assumes that you will continue to earn at the same rate and, therefore, you will pay roughly the same amount of tax in the following year.
If you’re going into full-time work or expect most of your earnings to be taxed at source, you might be able to reduce your payment on account. But if you reduce the payment and then end up underpaying tax as a result, HMRC can charge you interest and possibly penalties on the sum involved. Your accountant will be able to advise on the best course of action.
Once you are over the initial hurdle, payments on account simply spread your tax bill across the year and can make it easier to budget.
Ultimately, it highlights the importance of filing your tax return as early as possible – especially if you are newly self-employed – to avoid any nasty January surprises.