When you start working for yourself as a self employed individual, an initial benefit is that you don’t pay tax as you earn – unlike as in the PAYE system, in which employees get their taxes get deducted at source, based on their earnings.
As a self-employed worker, your first tax bill is most 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 your business in, say, October 2016, you wouldn’t have to pay tax until the Self Assessment deadline for 2016/17, which is January 31 2018.
Shocked by the First bill
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 2016/17 bill that you need to settle by midnight on 31st January, you also need to pay half of your total expected 2017/18 tax by the same deadline. The other half of the 2017/18 bill is then due on 31st July.
This way, HMRC ensures that self-employed individuals aren’t benefiting by being able to pay considerable amounts of tax many months in arrears.
The result for the newly self-employed individuals is that they face a tax bill which is almost 50% higher than what they had expected.
Penalties on Late Payments
Payment on account is something that is not widely known about amongst individuals who have never been part of the Self Assessment system. If an individual has been expecting a tax bill of £10,000, having to find an extra £5,000 to cover the first payment on account could be very difficult.
If the whole tax bill cannot be paid by 31st January, you are likely to face interest charges on the outstanding amount.
Adjusting the payment
The payment on account is based on the tax bill for the previous financial year. HMRC assumes that one will continue to earn at the same rate and hence will pay approximately the same amount of tax in the forthcoming year.
Individuals working as employees should expect most of their earnings to be taxed at source, in which case the payment on account could be reduced. However, if the payment on account is reduced and then the individual ends up underpaying tax as a result, HMRC can charge interest and possibly penalties on the sum involved.
Payments on account help spread your tax bill across the year and make the cash flow management easier.