One of the most common questions from sole traders is:
“How much should I be saving for tax?”
Unfortunately, there isn’t one percentage that works for everybody.
Your tax bill depends on your profit, other income, personal circumstances and whether Payments on Account apply.
But there are some practical ways to avoid reaching January without enough money available.
Remember: turnover isn’t profit
If your business receives £60,000 during the year, that does not necessarily mean you are taxed on £60,000.
A sole trader is generally taxed on taxable business profits rather than turnover.
Allowable business expenses reduce the profit on which tax is calculated.
That makes good bookkeeping important.
Without reasonably up-to-date figures, it is difficult to know how much profit you are actually making and therefore how much tax you should save.
Your Self Assessment bill can contain more than Income Tax
Depending on your circumstances, your Self Assessment liability can include items such as:
- Income Tax;
- Class 4 National Insurance;
- tax on property income;
- tax on dividends or savings;
- student loan repayments;
- other amounts collected through Self Assessment.
That is why simply putting aside 20% of everything you receive does not necessarily produce the right answer.
Use last year’s tax as a starting point
If your circumstances are relatively stable, last year’s accounts can provide a useful starting point.
Look at your previous taxable profit and total tax liability.
Then compare that with what is happening this year.
If profits are running 20% higher, saving exactly the same amount as last year is unlikely to be enough.
If profits have fallen, the opposite may be true.
Regular management accounts or bookkeeping reports make this much easier.
What about the 25% or 30% rule?
Some sole traders choose to transfer a percentage of income or profit into a separate tax account every month.
Something around 25% to 30% may provide a useful starting point for some basic rate taxpayers, but it should not be treated as a tax calculation.
Someone paying higher rate tax or with other taxable income may need to save considerably more.
Someone with lower profits may need less.
The important point is to base the figure on your own circumstances.
Don’t forget Payments on Account
This is where cash flow planning often goes wrong.
Your January payment can include tax relating to the year already completed plus a Payment on Account towards the following tax year.
That can make the amount leaving the bank considerably higher than the headline tax figure for one year.
If you are new to Self Assessment, understanding this before your first large payment is particularly important.
Keep tax money separate
A simple practical approach is to maintain a separate savings account for tax.
When the business receives money, transfer an agreed amount into the tax account.
It does not have to be perfect every month.
The purpose is to prevent all of the money in the current account being treated as available to spend.
You can then review the amount during the year as better figures become available.
Tax planning is easier with current figures
The closer your bookkeeping is to real time, the easier tax planning becomes.
Instead of asking in January:
“How much tax do I owe?”
you can be asking throughout the year:
“Am I saving enough for the tax I’m likely to owe?”
That is a much better position for any business owner.
