Payments on account explained

Why the system exists

An employee pays tax every time they are paid. By the time the tax year ends, HMRC already has the money. Somebody who is self employed pays nothing until the following January, so HMRC would be waiting up to 22 months for tax on income earned at the start of a year.

Payments on account close that gap. Rather than asking you to guess what you will earn, HMRC assumes you will earn roughly what you earned last year, and asks for that amount in two instalments as the year goes along. It is a cash flow mechanism, not an extra tax. You are not paying more, you are paying earlier.

When they apply to you

Two conditions have to be met. Your Self Assessment bill for the year must be more than £1,000, and less than 80% of your total tax for the year must have been collected at source, meaning through PAYE or through deductions such as those under the Construction Industry Scheme.

That second test explains why some people never encounter payments on account. An employee with a modest amount of rental income may owe £1,500 through Self Assessment, but if the vast majority of their tax came out of their salary through PAYE, they fall under the 80% test and no payments on account arise.

It also explains why CIS subcontractors are often exempt. If 20% has been deducted from every invoice all year, most of the tax has already been collected, so the 80% test is usually met.

The arithmetic, step by step

Let me use a real shaped example. Priya starts working for herself in the 2025/26 tax year, which ran from 6 April 2025 to 5 April 2026. Her profit gives her a tax and National Insurance bill of £6,000.

On 31 January 2027 she must pay the £6,000 for 2025/26. That is her balancing payment. Because the bill is over £1,000 and none of it was collected at source, she must also pay a first payment on account for 2026/27. That is half of £6,000, so £3,000. Her total on 31 January 2027 is £9,000.

On 31 July 2027 the second payment on account of £3,000 is due. By that point she has paid £12,000 in six months against a tax bill of £6,000, with £6,000 of it being credit against a year that has not been assessed yet.

Now move forward. Suppose her 2026/27 bill also comes out at £6,000. On 31 January 2028 she has already paid £6,000 in payments on account, so her balancing payment is nil. But she still owes a first payment on account for 2027/28 of £3,000. So she pays £3,000 in January and £3,000 in July. From year two onwards the burden evens out completely, and it is only the first year that hurts.

Why the first year feels so brutal

The reason is simply that the first year doubles up. You settle a full year in arrears at the same moment you start paying a year in advance. Nobody warns you at the point you register, HMRC does not send a heads up, and the figure only appears on your calculation once the return is filed.

Priya's experience is typical. She budgeted carefully, put aside £6,000 through the year, filed in January feeling organised, and then discovered she needed £9,000. That is not a tax problem, it is a cash flow shock, and it is the most common reason a healthy new business suddenly finds itself borrowing.

The fix is to know it is coming. From the day you start trading, set aside enough for one and a half years of tax across your first two years, rather than one year. In practice that means putting away closer to 40% of profit in year one rather than the 25% or 30% the tax alone would suggest.

Reducing your payments on account

Payments on account are based on last year, but you are allowed to tell HMRC that this year will be lower. If your income has genuinely fallen, if you have taken time off, if you have lost a major client, or if you have moved into employment, you can make a claim to reduce them.

You can do this through your online account or on the tax return itself. There is no need to justify it in detail at the time, though you should be able to explain the reasoning if asked.

The important warning is what happens if you reduce them too far. If you cut your payments to £1,000 and the eventual bill turns out to be £5,000, HMRC charges interest on the shortfall as though you had underpaid from the original due dates. In serious cases where a reduction was made carelessly or deliberately without grounds, a penalty can follow as well.

So reduce them where the fall in income is real, but do not reduce them out of optimism. If you are unsure, it is usually better to pay the full amount and receive a repayment later than to underpay and be charged interest.

What happens when income rises

The reverse situation is more comfortable but still worth planning for. If Priya's second year is much better, say a bill of £10,000 against payments on account of £6,000, then on 31 January she owes a balancing payment of £4,000 plus a first payment on account of £5,000, which is half of the new £10,000 figure. That is £9,000 in January and another £5,000 in July.

Growth therefore has a tax cost that arrives all at once. Any business that grows quickly needs to expect the January after a strong year to be expensive, and to hold money back accordingly rather than reinvesting every penny.

Making Tax Digital does not change this

There is a common misunderstanding that quarterly reporting under Making Tax Digital replaces payments on account with quarterly tax payments. It does not. The quarterly updates that began in April 2026 for those earning over £50,000 are reporting only. They tell HMRC your figures, they do not create a tax charge.

The payment dates remain 31 January and 31 July exactly as before. If anything, quarterly reporting makes payments on account easier to manage, because you have a much better idea during the year of what your final bill will look like, which makes a reduction claim easier to justify where income has genuinely dropped.

How the payments show on your statement

HMRC's online statement can be confusing because it shows the balancing payment and the payment on account as separate lines against different tax years. People often pay one and not the other, or pay the total and then panic when the statement still shows an amount outstanding for the following year.

The simplest approach is to look at the figure labelled as due by 31 January, pay that in full using your UTR followed by the letter K as the reference, and then diarise the July figure separately. If you pay a single lump sum HMRC will normally allocate it correctly, but where several years are open it is worth checking the allocation afterwards rather than assuming.

If you cannot pay

Payments on account can be included in a Time to Pay arrangement in the same way as any other Self Assessment liability. For debts up to £30,000 this can usually be set up online provided your returns are up to date.

Interest continues to run on anything paid late, so an arrangement is not free, but it stops the position deteriorating and it avoids the late payment penalties that would otherwise arrive at 30 days, 6 months and 12 months. As always, the return itself must be filed on time regardless of whether the money is available.

The habit that solves it permanently

Every self employed person I have ever seen manage tax comfortably does the same thing. They open a second bank account, and every time money comes in, a fixed percentage moves across immediately. Not at the end of the month, not when they remember, immediately.

For most sole traders somewhere between 30% and 40% of profit is the right figure once National Insurance and payments on account are counted. The account is never touched for anything else. When January arrives the money is simply there, and the size of the bill stops mattering.

It sounds almost too simple to be worth saying, but the difference between businesses that find tax stressful and businesses that do not is almost never how much they earn. It is whether the money was separated the day it arrived.

A worked example with a falling income

It helps to see the reduction claim in action. Marcus had a strong 2025/26 and ended up with a tax bill of £12,000. That sets his payments on account for 2026/27 at £6,000 each, due in January and July 2027.

Part way through 2026/27 he loses his largest client and his income halves. Left alone, he would pay £12,000 across the year against an eventual bill of around £5,000, leaving HMRC holding £7,000 of his money until January 2028. That is money he needs now.

So he makes a claim to reduce his payments on account to £2,500 each, based on his realistic estimate of the year. He pays £2,500 in January and £2,500 in July instead of £6,000 twice, freeing up £7,000 of cash at exactly the point his business needs it.

When he files his 2026/27 return the actual bill comes out at £5,200. He has paid £5,000, so a small balancing payment of £200 is due, plus interest on the £200 that was technically underpaid. That is a trivial cost for the cash flow benefit he gained. The claim worked because his estimate was honest and close to reality.

Had he instead reduced the payments to nil in the hope of sorting it out later, he would owe the full £5,200 in January plus interest running from the original due dates on both instalments, and he would have had a conversation with HMRC about whether the claim was made carelessly.

What happens if you stop trading

If you cease self employment part way through a year, payments on account already made do not disappear. They sit as credit against your final bill, and anything left over is repaid once the closing return is filed and processed.

You can also claim to reduce future payments on account to nil at the point you stop, since there will be no ongoing profit to tax. Doing that promptly avoids the awkward situation of paying money in July towards a business that closed in May, then waiting until the following February to get it back.

Frequently asked questions