What are Payments on Account
Payments on account are tax payments made twice a year by the self-employed and directors of Limited Companies, who receive dividends, to spread the cost of the year’s tax. They're calculated based on your previous year’s tax bill, and are due in two instalments.
The payment on account can be thought of as a way of paying off some of your tax bill in advance. The first instalment is due on 31 January (the same day as your 'balancing payment', which clears your tax bill for the previous tax year, see below), and the second is due on 31 July. It's meant to help you spread your payments out during the year.
Who has to make payments on account
If your Income Tax and class 4 National Insurance totals more than £1,000 for a tax year and you don't pay tax at source on more than 80% of your income, you'll have to make payments on account.
'Paying tax at source' is when the tax is taken off and paid over to HMRC before you receive the income - like your employer does if you are paid wages, under the pay as you earn (PAYE) scheme.
Payments on account are due on 31st January and 31st July, and are worked out as half the previous year's tax and class 4 National Insurance liability.
Class 2 National Insurance does not count towards payments on account.
Payments on Account are generally misunderstood, especially when a person is new to either self-employment or operating through a Limited company and can have a huge impact particularly in the first year of trading or where the business is growing and becoming more profitable.
To illustrate this point:
Emma, starts a self-employment business in retail. She has Income Tax and class 4 NI of £10,000 to pay for 2017/18, her first year of business. This is all due to be paid to HMRC by 31st January 2019.
Because her liability is over £1,000 and she does not pay tax at source, she must also make payments on account for 2018/19. These are due on 31st January 2019 and 31st July 2019, and are calculated at £5,000 for each of the two instalments.
That means that on 31st January 2019, Emma must pay £10,000 + £5,000 = £15,000 to HMRC, with a further payment of £5,000 by 31st July 2019.
When Emma actually prepares her tax return for 2018/19 and her liability for the year was say £12,500. She would have already paid £10,000 on account, so she must pay the additional £2,500 by 31 January 2020. This is called the 'balancing payment'.
She will also have to make payments on account for 2019/20 of £6,250 on or before 31st January 2020 and 31st July 2020
This means on 31 January 2020, Emma must pay a total of £8,750 = £2,500 (balancing payment + £6,250 1st payment on account for 2019/20.
If you consider that profits will fall in the following year, an election can be made to reduce the payments of account, however if your profits do not fall, HMRC may charge interest and even penalties on the underpaid of tax.