One of the biggest changes when you become self-employed is the fact that your tax isn’t deducted at source; instead you have to file a tax return each year and then pay the calculated amount. If you haven’t got the money to hand, this can lead to significant financial problems.
One way to ensure that you have enough money to pay your tax and national insurance contributions is to set up a separate bank account and transfer money into it regularly, then use the balance to settle your tax bills twice a year (July and January).
There are two ways you can save regularly:
- Estimate your annual income, calculate the tax on that income, and then set up a standing order for 1/12 (monthly) or 1/52 (weekly) of the tax due.
- Each time you receive payment for an invoice, transfer X% of the amount (after subtracting any costs directly associated with the invoice, e.g. if you’ve recharged travel costs to the client).
Personally I prefer the second option, as I already transfer money to my current account when invoices are paid, so splitting the funds two ways isn’t a lot of extra work. The hardest thing is working out what percentage I should transfer. I use a figure of 35%, on the basis that the tax + national insurance bands I fall into are: 0%, 29% and 42%. This tends to slightly overestimate the tax due, but I can always withdraw any excess once I’ve paid my bill from HMRC.
Given that you pay your tax in arrears, you can even profit slightly from this arrangement by keeping the ring-fenced funds in an account that pays interest, or by using an offset account to reduce the interest you pay on your mortgage.