Updated 22 January 2013
There is a lurking nightmare ready to strike many freelancers and the self-employed. Unlike employees, where tax is taken off before you receive your pay packet, freelancers are usually paid gross (pre-tax). But the psychology of this can cause financial havoc.
It’s something every newly self-employed person (or those who’ve never realised) needs to understand – another good reason for financial education in schools.
If you receive £100, it’s easy to think the money is yours – and that tax is just another bill to sort out each year when the time comes. That sentiment alone is enough to cause many to hit a tax-shock later when they realise they simply aren’t close to covering it, and not paying your tax is more than a little problem.
Instead, you need a different mindset. The secret, as I remember from my own freelance time, is to run by the mantra…
"For every £100 I’m paid, £30 isn’t mine."
Then EVERY time you get paid, simply siphon off the tax cash into a separate high interest savings account (see the Top Savings guide). That account shouldn’t be thought of as yours, you need to consider it "the taxman’s account" and as it’s someone else’s, you have no rights to it.
If you’re thinking your effective tax and National Insurance rate is less than this – perhaps you’ve many costs that can be offset – then alter the cash amount slightly (use the Income Tax Checker for a rough guide). But always err on the side of putting too much away. Then at the end of the year, once the taxman’s comfortably paid, any leftover money comes back to you.
Of course bigger earners paying higher or top rate tax may need to put away 40% or even 50% of what they get to hand over to our bowler hatted friend (not sure there should be an ‘r’ in that).
But I can’t afford to do that?
If that’s your response, there’s a real problem. Quite simply, the money isn’t yours, it’s the taxman’s. If you were an employee on the same pay, you’d never see this money. That’s how it works. Don’t allow yourself an undisciplined foray into this cash, or it usually just means you’re heading for big trouble.
In fact shifting cash aside isn’t just an effective trick in this situation alone. It’s actually the cornerstone of my piggybanking technique, which is all about putting your cash into lots of different accounts – not just for tax, but for bills and holidays too. It’s something many swear by (and a few act on).
I’d love your thoughts below on how you manage this, or how you’ve been caught out.
NB. The original February 2012 blog was written after the papers were full of news about TV presenter Miquita Oliver going bankrupt, owing the taxman £174,000. But that’s chip wrapping now, so I’ve removed it.