The tax bill isn’t the problem. The surprise is.
One of the most common conversations I have with sole traders and directors goes something like this: January arrives, the tax bill is bigger than expected, and the money is not there.
Not necessarily because the business had a bad year. Usually it is the opposite. The business did well, money came in, and nobody set enough aside.
Why self-employment catches people out
When you are employed, tax is deducted before your salary reaches your bank account. You never really have access to it.
When you are self-employed, your income arrives in full. There is no employer taking tax off first. So it is very easy to look at the balance in your account and think: that is my money.
Then there are Payments on Account
This is the part that turns an expected bill into a shock.
If you are required to make them, your January payment can include the tax for the year just gone plus the first payment towards the following year’s bill. A second payment is then normally due on 31 July. Each payment on account is usually half of the previous year’s relevant tax liability.
Tax for the year just gone: £6,000
First payment on account: £3,000
Due by 31 January: £9,000
Then a further £3,000 normally due by 31 July
So that £9,000 is not all tax for the year you have completed. £3,000 is an advance payment towards the following year. This is why the first January under payments on account can be so difficult — you are effectively paying one and a half years’ tax at once.
Payments on account do not apply to everyone. Broadly, they normally apply where the relevant tax liability from the previous year is £1,000 or more and less than 80% of your tax was collected at source.
The fix is a habit, not a calculation
Set up a separate savings account for tax.
Every time you get paid, move an appropriate amount across at the same time. Not at month end. Not when you remember. The same day.
The percentage you need will depend on your circumstances, including your profit level and any other income. It is worth working that out properly rather than picking a number and hoping. But the principle is simple: money that is not sitting in your current account is far less likely to be spent.
Two things that undo it
Dipping into the tax account. The moment it becomes a general cash flow buffer, it stops doing its job. If you find yourself borrowing from it regularly, the real issue is usually how quickly you are being paid rather than the tax itself.
Not watching profit during the year. If your income and profit are significantly higher than last year, your eventual liability may be higher too — and your payments on account, based on last year, will not have covered it. It is much better to know that in September than to discover it in January.
None of this makes the bill smaller
It simply means it does not have to come as a surprise. A tax bill you have planned for is an administrative task. The same bill, unplanned, is a cash flow crisis.
If you would like help working out what to set aside, or understanding whether payments on account apply to you, book a consultation.
This article sets out general information and is not advice for your circumstances.
