Provisional Tax - What Is It And How Does It Work?

No one likes talking about tax. But it’s a necessary evil, especially if you are self-employed and have to work it all out for yourself.

Everyone knows that at the end of the financial year, you fill in a tax return and then you have to pay some tax based on how much you earned. But did you know that depending on how much you earn, you might also have to pay tax upfront? That’s provisional tax.

So, how does provisional tax work and will you have to pay it?

In this article, we’ll explore exactly what provisional tax is and how it works. Let’s jump in.

What Is Provisional Tax, And Who Has To Pay?

At the end of the financial year, you have to pay what’s known as residual tax. This is an income tax calculated based on earnings that you haven’t yet paid tax on. Note: this doesn’t include salaried wages as they are generally taxed at the source through PAYE.

If your residual tax bill is more than $5000, then it means you will need to pay provisional tax for the following year.

While no one likes having to part with their hard earned money for tax, you could view having to pay provisional tax as a positive thing. After all, you only have to pay more tax if you are earning more. So, the fact you are paying provisional tax means your business must be doing well.

How Do You Know If You Need To Pay It?

Will you need to pay provisional tax? You’ll find out if you need to pay provisional tax when you complete your tax return. Once you complete your tax return and know how much residual tax you owe, you’ll know if you’ve exceeded the provisional tax threshold.

What if you’ve earned a mixture of income types and paid tax on some of it? Some people may have mixed income where they’ve earned from a salary as well as self-employed income. Or, they may have already paid schedular tax on some income. Any earnings you have already paid tax on will not count towards residual or provisional tax bills. 

Do I Have To Pay It?

The answer is yes! If you meet the criteria for provisional tax then you will have to pay it.

The only way of avoiding provisional tax is to fall below the residual tax threshold of $5000. But, if you do that then you are limiting your income potential, and no one wants to do that! 

If your residual tax bill is more than $5000 in one financial year, then you will have to pay provisional tax the following financial year. Failing to do so could result in letters or calls from IRD and penalties for late payment.

How Do You Calculate Provisional Tax?

Your provisional tax liability is based on your expected profit for the coming year. There are four ways you can calculate that, and they are:

• Standard - This is the default option and the one used by many people. This method considers the tax you paid in the previous financial year and adds 5%. Unless you pick a different option, this is the method IRD will choose for you.

• Estimation - With this method you estimate what you think you will earn in the coming financial year. This is a good option to use if you think you will earn less than the previous year. But, it can be open to error and you might end up underpaying your tax or being penalised for getting your calculations wrong.

• Ratio - This method works out your tax as a percentage ratio of your GST return. It can be a good option if you are a GST-registered business and your income goes up and down from year to year.

• AIM - This is a new method which uses an accounting software like MYOB or Xero to calculate your provisional tax figures. It lets you pay off smaller amounts more often based on your actual profit and cashflow.

Ditch The Confusion And Leave It To An Expert

Many people find provisional tax confusing, so we don’t blame you if you’re feeling a bit overwhelmed by the whole idea.

The best thing to do is to leave it all to an expert like us. Our team of accounting and tax specialists can make sure your accounts are all up to date and prepare your tax returns. Then if you need to pay provisional tax in the next year, we can advise you on the best method to choose for your business.

We’ll also help you remember to pay your provisional tax installments so that you can always stay on top of things. 

Ready to get on top of your provisional tax? Then, get in touch with the Figuration team today.