IT contractors must plan for the bigger tax take

IT contractors and other self-employed individuals should file their income tax returns as early as possible so they know where they stand with the taxman.

By now, individuals who usually submit a tax return should have received a notice from HM Revenue & Customs asking them to complete a return for the 2008-09 tax year.

The self-employed should work out in advance what their tax liabilities are, so that they can organise their finances in these difficult trading conditions. In the past, individuals may have been inclined to wait until nearer the tax deadline dates before submitting a return. However, filing a return as soon as possible can provide a double benefit.

Firstly, the tax owed will be recalculated, which means your second payment on account - due on 31 July - will be based on what you actually owe rather than what you paid the preceding tax year, which may have been substantially more. Of course, if you expect your overall income for the current year to be significantly lower than the previous year, you can ask for your second payment on account to be adjusted.

But by filing your tax return early, the second benefit is that you know exactly what you owe for the next 12 months or so. There will be no danger of underpayment, which would be subject to interest, surcharges and - in cases of extreme underpayment - penalties, and you can plan your finances accordingly.

This principle applies to any taxpayer who is within the payments on account regime.

In terms of how you might prepare your accounts in the light of the new dividend and salary tax rates for top earners, the best advice, at present, is to ensure you are on top of all paper work, so that before the new rates come in you have distributed all you can.

Looking at the new rates, and given the reality that some contractors will be considering permanent roles, it might be helpful to look at the current and proposed tax rates for a salaried individual:

As illustrated, there is an area of earnings just above the £100,000 threshold where the tax relief claw back has a huge effect.

Alistair Darling announced in his Budget that from April 2010, if an individual's gross income is above £100,000, the amount of their personal allowance will be reduced by £1 for every £2 of income above the threshold . Those earning above around £112,950 will receive no personal allowance at all.

In addition, from 2011/12 Employers NICs also increases which raises the cost of employing an individual. For a mid-top range contractor taking a salary the 50% is wishful thinking for each extra £1 they will earn.

And for contractors operating through a small company, dividends (to be taxed at 42.5%) taken from the company will compare favourably with salaries, and there is now a significant gap between the two.

I expect HMRC inspectors to be brushing off their IR35 manuals, should there be a sudden rush to incorporate companies to take advantage of the lesser tax take.

For an IT contractor, and indeed any worker, now is a good time to plan ahead and consider what their post-tax income levels will be, once you factor in the new rates.

When looking at these models, the contractor should remember that there is bound to be uncertainty over the level of tax rates over the next few years particularly with a general election approaching.

Meanwhile, pension planning has always been seen as a way to reduce the tax burden and save for the future. With the proposed reduction in higher rate relief it is a good time to review pension payments, but care needs to be taken as there is proposed legislation to prevent people making large contributions before the new restrictions come in.

Finally, even where the contractor has the ability to operate through a limited company the tax rates are still very high. With the recent reduction in contractor pay rates, and the increased pressure from taxation and national insurance on what pay remains, I would imagine that there will be an increase in the use of tax mitigation schemes.

Comment based on the advice of Paul Spindler, of the technology group at chartered accountants Kingston Smith.