Payments on account: why your first tax bill can be 150% of what you expected

Of everything in the Self Assessment system, payments on account generate more alarmed phone calls than the rest combined. The mechanism is simple; the cash flow effect in a first profitable year is not.

What they are

A payment on account is an advance instalment towards next year’s tax bill. HMRC assumes you will earn roughly what you earned last year, and asks for the tax in two instalments rather than waiting.

Each instalment is 50% of your previous year’s tax liability. They fall due on 31 January and 31 July.

When they apply

You will be asked for payments on account if your Self Assessment liability is more than £1,000, unless more than 80% of your tax was already collected at source through PAYE.

Why the first year hurts

Suppose your tax bill for your first full year of trading is £5,000, due on 31 January.

That same 31 January, you also owe your first payment on account for the following year: 50% of £5,000, or £2,500.

So the January payment is £7,500, not £5,000 — one and a half times the figure you had in mind. A further £2,500 follows on 31 July.

Nothing has gone wrong and you have not been overcharged. The second year settles down, because by then you have already paid instalments towards it. But the first January is a genuine cash flow event, and the way to survive it is to know about it in advance.

If your income has fallen

Payments on account are based on last year, so if this year is worse you can apply to reduce them. Be careful: if you reduce them too far, HMRC charges interest on the shortfall from the original due dates. Reduce them on the basis of a realistic estimate, not optimism.

How to stay ahead of it

Set money aside as you earn rather than as the deadline approaches — a separate account you do not touch is the simplest system that works. A rough starting point for a sole trader is a quarter to a third of profit, refined once there are real figures to work from.

The other half is timing: getting your return prepared early. There is no advantage to filing in January. A return finished in the autumn tells you exactly what you owe with months to prepare, and it costs nothing extra. We aim to have client returns finished well before Christmas for exactly this reason.

General information, not advice. Talk to us about your own position.