If you’re not familiar with the self assessment system and all it’s quirky features then the first year of self assessment can deliver you a nasty surprise. After all a tax liability 50% higher than what you were expecting isn’t ideal shortly after the Christmas period. Unfortunately due to HMRC’s payment on account system this is the reality many face. In this article we will explain exactly how the payment on account system works and how best to prepare for it.
What Is A Payment On Account
Individuals who submit a self assessment may need to make a payment on account which is an instalment towards next years tax liability (and class 4 national insurance if you’re self employed). Payments on account are normally due by 31 January and the 31st July of the following year and are calculated as 50% of the prior years tax liability. They are based on the assumption that your tax liability will be the same in the following year. Where the payments on account result in an overpayment HMRC will refund the difference and where there is an underpayment the tax payer will need to make a balancing payment by 31st January following the end of the tax year.
It is not worthy that the payment on account doesn’t take into account other tax liabilities which such as capital gains which will need to be accounted for separately.
Example
You are a self employed individual submitting your first self assessment covering the 18/19 tax year. You have a tax liability in the 18/19 tax year of £4,000. This amount will be due by 31st January 2020 but on top of this you will need to start making payments on account towards your 19/20 tax liability. You will need to make the first payment on account of £2,000 by 31 January 2020 and the second payment on account of £2,000 by 31 July 2020. When you eventually submit your 19/20 self assessment your actual liability is is calculated to be £4,500. As you have already paid £4,000 towards this your balancing payment will be £500 due by 31 January 2021. You will also make your first payment on account for the following year by 31 January 2021 which will be calculated as 50% of £4,500. This cycle then continues year after year.
You will notice that in the first year the self employed individual doesn’t pay any tax until nearly 9 months after the end of the tax year but in every year following this they will actually start to pay their liability before the tax year has even finished.
Who Has To Make Payments On Account?
Anyone who submits a self assessment will need to make payments on account unless one of the following apply:
- Your last self assessment bill was less than £1,000
- You’ve already paid more than 80% of the tax you owe (usually when the majority of your income is taxed at source such is the case for employment income and UK bank interest
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Usually HMRC would prefer that income is taxed at source as it’s better for cash flow and makes income less likely to be underdeclared. A good example of income where tax is deducted at source is when you earn a salary. The PAYE system or “pay as you earn” does exactly what it says and collects tax as the liability arises. Unfortunately there are a number of income sources where this currently isn’t possible such as dividends and self employment. Without payments on account this results in some individuals not paying tax for a substantial period of time. For example a self employed builder who earns £3,000 in October 2020 wouldn’t need to pay the tax to HMRC until 31 January 2022. Assuming they are a basic rate tax payer and pay tax at a rate of 20% that leaves £600 of income tax in the builders pocket for 15 months longer than had they been in employment. Of course this creates an unfair advantage and leaves those with certain income types in a much more favourable position.
The aim of making payments on account is to somewhat level the playing field so there is no substantial benefit to receiving a certain type of income source.
Reducing Payments On Account
As the payment on account is calculated based on the prior tax years liability, it assumes a constant level of earnings from the same sources. Of course in reality this is rarely the case. Self employment profits will vary, dividends go up and down and rental income will increase or decrease depending on demand. This creates certain situations where the tax payer knows the payment on account is wrong and will result in them overpaying tax to HMRC. In this situation where the individual knows their liability will be lower next year because of reduced income, the individual can request to reduce their payments on account to a level they feel is appropriate.
To reduce the payment on account a request is made at the time of submitting the previous self assessment return so someone who feels they will have lower income in the 20/21 tax year will need to inform HMRC of this when submitting their 19/20 self assessment. The individual will need to provide HMRC for a valid reason for the reduced payment.
Be careful not to reduce the payment on account too much as if you end up underpaying tax as a result you’ll be charged interest by HMRC on the underpaid amount. On the other hand if your payments on account result in an overpayment you’ll simply be refunded the difference. If you have any doubts it’s best to speak to an accountant who can help ensure you don’t get caught out by over reducing the payment on account.
Covid-19 Related Delays
HMRC have allowed tax payers to defer their 31 July 2020 payment on account until 31 January 2021 and have confirmed that tax payers will not be charged interest or penalties providing the payment (and any balancing payment is made by 31 January 2021). HMRC suggest this option is only exercised if you are in financial difficulty and if not they are encouraging individuals to make payments as usual.
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Adam Hill
Practice based accountant with over 10 years experience, specialising in SME's, Freelancers and Personal Tax. "I take pride in proactively recognising tax planning opportunities on behalf of clients to help them operate more efficiently."
