In this article I’m going to explain how a “creator of literary work” (HMRC’s words not mine!) can use Averaging to reduce their tax bill. Don’t worry I’m going to try and keep the maths bit to a minimum, but for those who love a few sums I’ll highlight the calculation in orange. Essentially you can use averaging if you don’t pay tax in one year then pay tax in the next, or if you’re flicking between tax brackets. The effect is to smooth the profits over 2 or 5 years.
Its a bit more complex than that in reality and there are certain conditions that need to be met, but a good accountant (PICK ME! PICK ME!) will be able to explain your situation to you.
As any writer will tell you, writing a book and getting sales in can take a number of years. And the chances are, your creativity won’t fit neatly into the 5 April tax year. Book sales in one year might be OK, you’re making a profit but not enough to pay tax. Then suddenly a book takes off and you’re earning big bucks.
You have been plunged into the higher rate tax bracket and have an enormous tax bill stretching into tens of thousands. What can you do about it? In most other industries you would just have to ‘deal with it’. As a “creator of literary work” you don’t have to ‘deal with it’. You can average your profits over two or five years.
What does that mean, average your profits? Well, if you make £1,000 in one year and £55,000 in the second year, the average profit is £28,000 a year.
(MATHS BIT: £1,000 + £55,000 = £56,000 ÷ 2 years = £28,000).
If you were to earn £55,000 in a single year, you would have to pay tax at 40%, but now your profit is £28,000 you only pay tax at 20%.
Let’s walk through an example. This is a real scenario that a client had this year, so not a hypothetical classroom exercise. DISCLAIMER: The figures have been rounded to make the maths easier to follow and if I were to "show my workings" it would be over 4 pages of A4!
The profit in 2017/18 was £1,000. The personal allowance covered this, so no tax is due.
The profit in 2018/19 jumped to £55,000! The tax due is as follows:
Tax @ 20% £6,900
Tax @ 40% £3,460
Class 2 NI £153
Class 4 NI £3,586
Tax bill = £14,100
Plus a payment on account of £6,900
Add all this together and the total tax bill on 31st January would be £21,000
(MATHS BIT: 14,100 + 6,900 = 21,000)
Now if we average the two years the profit becomes £28,000 for each year. Both years are now under the higher rate bracket!
Now the tax bill looks like this:
The tax and NI due in the 2017/18 year is £5,230
The tax and NI due in the 2018/19 year is £5,140
Tax due £10,370
plus payment on account £2,495
The tax that is now due on 31st January is £12,865
(MATHS BIT: 10,370 + 2495 = 12,865)
This is a saving of over £8,000!
(MATHS BIT: 21,000 - 12,865 = 8,135)
You can see that the tax bill has almost been split in half between 2018 and 2019 (not quite because the personal allowance went up in 2019) and the payments on account have been slashed to less than £2,500 (from £6,900!).
Overall the tax bill is nearly half of what it was!