There are few things more perplexing to a new freelancer than a big unexpected bill from the Australian Tax Office (ATO). You lodge your tax return with the business income and then you pay your annual tax bill, right?
“So why are the ATO now telling me to pay more tax before my next tax return is due?!!”
You search the ATO website for answers and get lost in the word salad. It’s impossible to find a solution when you have no idea what the right outcome should be. Plus, lost or ignored mail and the pressure of a subsequent debt collection notice may have put you on the back foot.
In this article, we share how we often explain PAYG instalments to our clients, in layman’s terms.
PAYG instalments are payments of provisional income tax
Provisional tax isn’t an additional tax. It’s a way of “paying as you go” towards your anticipated income tax bill, as the income is received through the year. The amount of PAYG instalments paid during the year will offset your annual tax liability when you lodge your next tax return. You will get a tax refund or a tax bill for the difference.
It’s a good thing for freelance cash flow, really. Imagine that nice feeling at tax time, knowing that you’ve already paid. You just need to know how to manage the instalments.
All Australian taxpayers who report $4,000 or more gross business and/or investment income in their tax return, and owe more than $1,000 tax, are automatically put on the system. Business income is generally what you earn on your ABN and investment income includes bank interest, rent, etc. But “PAYG instalment income” does not include wages and salary income from which PAYG is normally withheld.
The ATO work out how much you will owe for the next year based on the income declared in your most recently lodged tax return. You will have to pay the ATO-calculated amounts unless you calculate your own instalments based on your actual current year income.
Although some businesses pay monthly, most sole traders pay quarterly and we will talk bout quarterly instalments here.
Be prepared for future quarterly statements
So, if your tax return lodgment waves a flag, the ‘ATO super computer’ should automatically send you an information letter welcoming you to the PAYG system. It may say: “you do not need to do anything right now… we will send you statements later”.
This is a cue to prepare yourself for the quarterly PAYG instalment ‘activity statements’ that you will receive in future:
- Check the ATO have your correct mailing address on file for ‘activity statements’. The address updates for your income tax letters don’t cross-update for activity statements.
- Register for MyGov and link your ATO account. Here you will be able to update your addresses, access and lodge your Activity Statements and see your due dates and amounts owing.
- Make sure your year-to-date business income and expenses are entered in your accounting system.
To report and pay their instalments, the ATO send taxpayers either:
- PAYG Instalment Notices – these tell you what to pay or give you the option vary the amount before the date the ATO amount falls due; or
- Instalment Activity Statements (IAS) – these give you the option to calculate the instalment amount yourself, based on your actual income and a percentage rate; or
- Business Activity Statement (BAS) – if you are GST registered, your BAS will include the options above of paying PAYG instalments.
Note: The activity statements for PAYG (1 & 2) should not be confused with a ‘Business Activity Statements’ (BAS) which is for reporting GST. If you are GST registered, you will see a field on your BAS for PAYG instalments. If you are NOT registered for GST, you will only receive an activity statement for PAYG (1 or 2).
Take notice of the due date
Quarterly Activity Statements are due on the 28th day of the month after the relevant quarter.
It’s important to know that PAYG Instalment Notices do not have to be lodged to the ATO unless you choose to vary the amount payable. The ATO amount on the notice will become automatically payable on the due date, and you cannot vary the amount after the due date.
Instalment Activity Statements (IAS), on the other hand, must be prepared and lodged. Failure to lodge an IAS by the due date can result in penalties.
Why should I vary the PAYG instalment, and how?
For example, let’s say you’re on top of this. Your accounting records are up to date. You’re aware of the due date. You have received a PAYG instalment Notice with an amount to pay.
The ATO based your PAYG instalments on last year’s business income and expect you to pay $20,000 in total, or $5,000 per quarter. But this financial year you are earning less on your ABN. You don’t want to pay the ATO more than you will owe even if it will be eventually refunded, because you need the cash.
So, you prepare an estimate of your tax payable for this year and it comes to $10,000. You enter your annual tax estimate of $10,000 in the section to vary your instalment. Divided by 4, that equals a varied instalment amount of $2,500 per quarter (instead of $5,000). If you overpaid in the previous quarter, you can claim a credit for the overpaid amount based on your new tax estimate.
The ATO already processed my PAYG instalment amount, and I can’t vary it now. What do I do?
Let’s say, for example, you were not on top of this. You didn’t vary your instalment before the due date. Now you have a bill you can’t afford to pay, and don’t expect to owe based on this year’s tax estimate, and the ATO are demanding payment.
The important first step is to set up a payment plan, to start paying off the debt over time. You can do this on MyGov. As long as you don’t default on payments, you should avoid the debt collectors and buy some time to sort it out next quarter. There may be some interest charges, but they will be tax deductible.
When you receive next quarter’s statement, you can vary the instalments for the year and claim a credit for the previous quarter’s instalment if it was too high. When you lodge your varied PAYG instalment notice, it should all come out in the wash, so to speak, and your future instalments will be based on your annual tax estimate until you lodge another tax return.
Can I opt out or minimise my instalments?
Although it is technically possible to ‘opt out’ of PAYG instalments or to vary your PAYG instalments to a smaller amount than you reasonably expect to owe, this course of action is not recommended.
The ATO can later charge penalties and interest if you underestimate your PAYG instalments. Once you lodge a varied instalment statement reducing the amounts you pay, you are obliged to “vary up” your future instalments if expecting a higher annual liability than was previously estimated.
Besides, it’s better to pay the right amounts as you go along to avoid dealing with a big bill down the track.
How do I prepare an annual tax estimate?
This is not easily explained. Basically, it’s like doing your tax return in advance. Of course, that will be easier if your accounting records are up to date and we’re more than halfway through the tax year. You can project the rest of the tax year’s net profit (income minus expenses) and add it to the year-to-date net profit, to arrive at an estimated annual net profit for tax estimate purposes.
If you have stopped earning ABN and investment income altogether, a nil tax estimate may be easily arrived at.
The ATO have a basic PAYG instalments calculator on their website. You can attempt this or ask your accountant for an annual tax estimate.
A ball park figure can be calculated by looking at the tax rate applicable to your tax bracket for the year and applying that rate to your estimated annual net profit.
See the ATO Individual Tax Rates. Say, for example, you expect to earn $40,000 gross wages/salary plus $30,000 net profit from your ABN freelancing activities. The 32.5% tax rate plus 2% Medicare Levy would apply to the $30,000, resulting in an estimated annual tax liability of $10,350 (disregarding any tax offsets and assuming your employers withhold enough PAYG from your wages).
How can I calculate my own instalments each quarter based on what I’m really earning?
If you receive a PAYG Instalment Activity Statement for the first the first quarter of the tax year, July to September, you can exercise this choice by selecting ‘Option 2 – Calculate my instalment’. If you do this from the first quarter, you will be given the option to calculate your instalments based on actual income in future quarters. Otherwise your only option will be to pay the ATO amounts on the PAYG instalment notices – it’s harder to vary these instalments if needed because you have to prepare annual tax estimates.
Your PAYG instalment income includes your GROSS business income (net of GST and before expenses) and investment income for the quarterly period. Do not enter your net profit and only include income that has been paid to you in the quarter (Most sole traders report on a cash basis).
Apply the instalment rate to the quarterly PAYG instalment income amount to arrive at the amount payable. For example: 20% rate x $10,000 income = $2,000 PAYG instalment.
It’s important to lodge an IAS by the due date. Otherwise, there are penalties starting from $210 for failure to lodge on time. For this reason, some people manage better with PAYG Instalment Notices.
How do I vary the ATO instalment rate?
The ATO will have calculated your PAYG instalment rate based on your previous tax return outcome. However, you can vary this rate up or down if it results in an instalment amount which is at odds with your estimated annual tax liability. For example, this year you may expect to incur much higher business expenditure – accordingly, you would reduce the percentage rate. If your business expenses will substantially reduce, you may choose to increase the rate.
The ATO provide some instructions to vary your rate here.
Some other tips
When a freelancer lodges their first tax return with business income and has a bill to pay, it can come as a shock to have to pay these instalments as well, especially if the tax return was lodged a bit late.
That’s why we recommend when freelancers apply for an ABN, or when they start invoicing clients, that they call the ATO and ask to be put onto the PAYG instalment system ASAP instead of waiting until after a tax return is lodged. That way, the cash flow will be better managed from the very beginning and there will be no nasty surprises. In future, we hope the ATO finds a way to automate this with ABN applications.
If you are a special professional (claiming income averaging in your tax returns), the ATO may put you onto their odd system where you nothing in quarter 1, nothing in quarter 2, then a huge 9 months’ worth of PAYG instalments for quarter 3. The ATO’s idea is that it gives special professionals the option to estimate their tax later in the year, because they typically have fluctuating income. In our experience, though, it is impractical and sends our clients into shock to receive a bill for such a large amount that they haven’t put aside funds for. This outcome may be avoided by choosing to calculate your own instalment amount in quarter 1 (July to September) and in subsequent quarters, instead of ticking the option to pay a nil amount.
Some people receive Annual PAYG Instalments, which are due 28 July. We usually recommend doing the tax return early, by 28 July, so that the actual tax liability can be declared. Otherwise, the ATO instalment will have to be paid for 12 months. It will all “come out in the wash”, so to speak, when the tax return is eventually lodged.
Sometimes, we find that the ‘ATO super-computer’ acts in mysterious ways and doesn’t even put people onto the PAYG instalment system when it should. Sometimes it even takes people off the system when it shouldn’t! If something like that happens and you know you will owe tax in future, then it is possible to phone the ATO and ask to be issued quarterly statements, so you can PAY AS YOU GO.
We hope this article was helpful. Please be aware that all of this information is general in nature; it does not take into account your own circumstances and, as such, is not intended to be taken as advice. Should you require further information or assistance with your PAYG instalments seek professional advice.
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