What are payments on account?

How do payments on account work?

HMRC assumes next year will look like this year. So once your Self Assessment bill is known, it asks for half of it again on 31 January and half on 31 July, as a deposit against the year you are already trading through. When that year's return is filed, the deposits come off the bill and you pay, or are refunded, the difference.

They apply only when the bill is above a modest threshold and most of your tax was not already collected at source through PAYE. The current figures are on gov.uk.

The effect is that your first January as a sole trader can cost one and a half years of tax at once — the year just finished, plus half of the year ahead. It is the single most common cash shock in the first year of self-employment.

A worked example

A freelance designer's first full year of trading produces a Self Assessment bill of £6,000. On 31 January she pays that £6,000, plus a first payment on account of £3,000 towards the next year. On 31 July she pays the second £3,000.

Her second year turns out slightly better and the bill is £7,000. She has already paid £6,000 on account, so on 31 January she pays the £1,000 balance — plus a first payment on account for year three of £3,500. The July payment is then £3,500.

What do people get wrong?

Treating the July payment as optional. It is a legal instalment, and interest runs from the day it is late.

The other mistake is not reducing them when income falls. If you know next year's profit will be lower, you can ask HMRC to reduce the payments on account. Reduce them too far, though, and interest is charged on the shortfall, so estimate honestly rather than optimistically.