The BIG Guide to Payments on Account

Why your first tax bill hurts

Payments on account are one of the biggest shocks for people who become self-employed.

Every year we end up having the same conversation with someone who says:

“Why has my tax bill doubled?”

Usually, it hasn’t.

What has happened is that HMRC has asked for some of your next tax bill early, and that is the bit that catches people off guard. HMRC’s payments-on-account rules usually apply where your Self Assessment bill is more than £1,000 and less than 80% of your tax has already been collected at source, such as through PAYE.

This guide explains:

• what payments on account are

• when they apply

• why the first bill feels painful

• how to manage them properly

What payments on account actually are

Payments on account are advance payments towards your next tax bill.

They usually affect people who file a Self Assessment tax return, such as sole traders, freelancers, landlords, and some company directors or shareholders with enough untaxed income. HMRC says they are advance payments towards your next bill, based on the previous year.

The bit that is easy to miss is this:

they are normally based on your previous year’s Income Tax and Class 4 National Insurance, after tax deducted at source is taken into account. They are not normally calculated on Capital Gains Tax or Student Loan repayments, which stay in the balancing payment instead.

That is why your payments on account can look big, but still not match every line on your tax calculation.

When payments on account apply

They normally apply when:

• your relevant tax bill is more than £1,000, and

• less than 80% of that tax has already been deducted at source, for example through PAYE.

If both of those are true, HMRC will usually ask for advance payments.

This is why many employees never really notice the system. If most of their tax is already collected through PAYE, payments on account often do not kick in.

How payments on account work

Payments on account are based on your previous year’s bill.

You normally make two payments towards the following year’s tax:

• 31 January

• 31 July

Each payment is usually 50% of the previous year’s relevant bill. HMRC’s rules say each payment on account is equal to 50% of that relevant amount.

So if your previous year’s relevant bill was £4,000, HMRC would usually ask for:

• £2,000 on 31 January

• £2,000 on 31 July

And on that first 31 January, you are often paying two things at once:

• the balancing payment for the year just ended

• the first payment on account for the next year

That is why the first January can feel especially grim.

Example: why the first bill feels painful

Let’s say your first Self Assessment tax bill comes out at £4,000, and it all falls into the payments-on-account calculation.

HMRC may ask you to pay:

• £4,000 for the tax already owed

• £2,000 as the first payment on account for the next year

So the amount due on 31 January becomes £6,000.

Then, on 31 July, you pay the second payment on account of £2,000.

Across those two dates, you have paid £8,000, even though your original tax bill was £4,000.

That is why people feel like their tax has doubled.

It hasn’t.

You have just paid part of the next year’s bill early.

What happens the following year?

The following year, HMRC compares:

• the payments on account you already made

• your actual tax bill for that year

If the payments on account were too high, they reduce what is left to pay, or create an overpayment.

If they were too low, you pay the difference as part of the balancing payment.

This is why payments on account usually feel worst the first time. Once you are a year or two in, the system tends to settle into a rhythm.

When payments on account do not apply

Payments on account do not usually apply if:

• your relevant bill is £1,000 or less, or

• more than 80% of the tax has already been collected at source.

That is why lots of people never really encounter them until they become self-employed, start receiving rental income, or begin getting more untaxed income outside PAYE.

Can you reduce payments on account?

Yes. If your income has genuinely fallen.

That can happen if:

• business slows down

• you stop trading

• rental income drops

• you move into a lower-income year

• you switch from self-employment to a limited company structure and your personal untaxed income falls

HMRC lets you claim to reduce payments on account online. But if you reduce them too far and your bill turns out to be higher than expected, HMRC can charge interest on the difference.

So yes, you can reduce them.

But it needs to be because the numbers have genuinely changed, not because the January bill looks annoying.

The biggest mistake people make

The biggest mistake is spending all the money during the year and forgetting the tax bill is coming.

Because payments on account effectively mean you may need to fund:

• last year’s tax

• plus part of next year’s tax

That is why the first big Self Assessment deadline often feels brutal. It is not always the tax rate that hurts. It is the timing.

A simple habit helps: set money aside as you go.

A lot of self-employed people use a separate tax pot so the money is sitting there when the bill lands.

The landlord surprise

Payments on account also catch out a lot of landlords, especially accidental landlords.

Someone moves in with a partner.
Rents out the old place.
Starts receiving rental income.

Then the first tax bill arrives, and the next thing they discover is that HMRC wants part of the following year early as well.

It is the same payments-on-account system. It just tends to surprise people more because they do not think of themselves as “running a business”, even though Self Assessment still applies.

Limited companies and payments on account

If you run a limited company, this particular system does not usually apply to the company’s Corporation Tax.

Corporation Tax has its own payment rules. Smaller companies usually pay by the normal Corporation Tax due date, while large companies can have to pay by quarterly instalments instead.

But you personally may still have payments on account if you receive untaxed income, such as:

• dividends

• rental income

• other income not fully taxed at source

So the company and the individual need to be thought about separately.

A quick reality check

Payments on account feel unfair to a lot of people the first time they see them.

But the logic is fairly simple: HMRC does not want people paying a big tax bill long after the income has been earned. So once your tax pattern settles down, payments on account are meant to keep you closer to the right level through the year.

Not fun.

But not random either.

The simple way to manage them

A few habits make payments on account much less painful:

• set aside money for tax during the year

• keep your records up to date

• review profits regularly

• plan ahead before January arrives

Do that, and payments on account usually become predictable instead of nasty.

Final thought

Payments on account are one of those things that catches people badly the first time.

After that, most business owners settle into the rhythm.

The key thing to understand is that you are not being taxed twice.

You are simply paying part of next year’s tax early.

Once that clicks, the whole thing becomes much easier to plan for.