Did January end with a shock for you? Was your personal tax bill a lot bigger than you expected? Maybe the scenario below sounds familiar?
Mark is in his full year of self employment and everything is going well. He did a tax return last year but there was only a few months self employment included so no tax to pay. It’s now early January and although he’s a bit last minute with his accounts (and not popular with his accountant), he’s confident that he’s got enough money put aside to pay his bill. He’s estimated his profits at £20,000 so after the £10,000 personal allowance that leaves £10,000 to pay tax on. Income tax is 20% so that gives him £2,000 to pay. He’s made sure that he’s got that £2,000 saved and ready for the 31 Jan. He’s feeling pleased with himself for being prepared.
The books go to his accountant and in the last minute January flurry he doesn’t hear anything for a week or so. Just a week to go before the payment deadline and his accounts and tax return come back. He was spot on with his profit estimate, but wait a minute, £4,625,94 tax, you must be joking, where did that come from? An extra £2,600 with only a week to find it is a serious cashflow issue for a small business.
So what happened, why was Mark’s tax bill so much higher than expected? This is a worst case scenario, but one that does happen. The income tax rate is common knowledge and there is a lot of publicity on the news each year about the personal allowance, but there are a couple of things that don’t get so such coverage and often catch people out.
Class 4 National Insurance
Payments on account
Class 4 National Insurance
If you are self employed you have two types of National Insurance contributions (NIC) that you might pay: Class 4 and Class 2. In the past Class 2 has been a monthly payment, often by direct debit (although this is changing). Class 4 NIC is calculated as part of the self assessment at year end, in the same way as your income tax, and is currently charged at 9%.
We generally know the tax free threshold or personal allowance for the year as this is always one of the budget headliners. However, the threshold for Class 4 NIC is not the same as for tax, it is generally lower. For 2014-15 you had to pay tax on earning above £10,000 but you had to pay Class 4 NIC on earnings above £7,956, a difference of £2,044. For 2015-16 the personal allowance for tax is £10,600 but the Class 4 NIC threshold is only £8,060, a £2,540 difference. This means you pay Class 4 NIC on more of your income than you do for tax.
People often leave the Class 4 NIC out of their calculations but at 9% it can make a significant difference. In the example above it adds an additional £1,083.96 onto the £2,000 income tax bill. It can also cause an unexpected tax bill where someone is below the personal allowance but above the NIC threshold.
Payments on account
This is the area that really catches a lot of people out, particularly in the first year of trading or if the business has been growing.
Payments on account kick in when your tax bill hits £1,000 (providing the majority of this tax wasn’t deducted via PAYE during the year). The first payment in advance is due 31 Jan and the second 31 July. HMRC assume that your profit will stay approximately the same, so the payments are calculated by dividing your current tax bill in half e.g. if your bill for 2014-15 was £2,000 then each payment on account for 2015-16 would be £1,000.
Because the payments are calculated based on the combined tax and NIC total, they can add significantly to your January bill. It is possible to adjust the payments on account on the tax return if you know that your income is going to be significantly higher or lower.
Once you are up and running with payments on account, they’re generally not so bad. They do force you to spread your tax saving so it doesn’t all come in one lump and if your income is fairly steady there may be very little adjustment needed in January, you might even get a bit of tax back. The main issue is that if you aren’t aware they are coming, they can really deal you a hefty cash flow blow in the first year.
If you have a variable profit then for you the payments on account may come and go. You might overpay one year and get a refund, only to have them kick in with the double January payment next year. If this is you, then unless you know that your profit decrease is truly a permanent situation, you might want to use your refunds to offset against future tax bills. There is an option to do this in your tax return. That way you are creating a buffer against the next nasty surprise.
Why do we have to make payments on account?
It seems a bit mean to ask for a year and a half’s worth of tax in one go, but from HMRC’s perspective it is only fair. Think about when the government receives tax from PAYE compared to when they receive tax from self assessment.
John is employed on PAYE. He gets paid in April 2015. The government receive his tax and NIC deductions by 19 May 2015.
Jill is self employed. April 2015 falls into her 2015-16 year end. The tax for that year isn’t due until Jan 2017. It takes almost 2 years longer for HMRC to receive Jill’s April 15 tax compared to John’s.
Payments on account are way to shorten the tax time lag for HMRC. If Jill has payments on account then HMRC get the first amount for 2015-16 in Jan 2016, a whole year earlier than they would have done.
And don’t forget Class 2 NIC
You might have noticed that you are no longer paying a Class 2 NIC direct debit? For the tax year 2015-16 onwards the Class 2 NIC will be calculated and collected as part of your self assessment tax return in the same way as Class 4 NIC.
Although this gives the potential for another “surprise” item on the tax bill, the good news is that the Class 2 NIC doesn’t count towards the figure that HMRC will use to work out your payment on account; that will continue as the combination of income tax and Class 4 only.
What can you do if you can’t pay?
If you’ve been hit by an unexpectedly large tax bill and you know that you don’t have the funds to pay it, it’s really important not to bury your head in the sand.
Make sure your tax return is submitted on time, whether or not you know you can pay as there are fines for not submitting the return. The longer you wait the more fines you’ll have in addition to any tax due.
Speak to HMRC as soon as you can about your difficulties. They prefer it if you make contact and are often willing to agree a payment plan, depending on your particular circumstances.
Contact for HMRC – https://www.gov.uk/difficulties-paying-hmrc/overview
Think about next year
It’s never too early to plan ahead to next year! Just a little time spent each month keeping on top of some bookkeeping can save a lot of time, stress and cash flow issues down the line. If you have an idea approximately how much profit you are making each month, you can start to put something aside for tax. If you are doing this in real time, then even if you end up with tax and payments in advance (effectively 18 months worth of tax) you should have enough saved up. Say you started putting some tax money aside in April 16 then by the time it gets to Jan 18 when the tax bill is due you should have been saving for 21 months and have more than enough to cover your bill and first payment on account. If you are already into payments on account then monthly saving will help spread the blow a little.
The best bit about saving in real time is that you don’t have to be super-accurate. The tax calculation can be quite complicated with the tax and NI to take into account, both with different thresholds. If you are saving in real time then effectively you are always well ahead of your tax bill and have a lot more wiggle-room. If you aren’t sure whether you’ll need to pay tax or not then having a small savings buffer at hand just in case can be helpful for emergency cash flow situations as well as tax.