Budgeting basics for IT contractors

As an IT contractor operating your own limited company, there are a number of reasons why budgeting may be important.

Budgeting; why bother?

Your income may seem fairly fixed, and your costs might not fluctuate much either. However, there could be a number of tax and other liabilities, which could leave the unwary struggling to find the money to pay. In short, budgeting basics for IT contractors are a must-know, especially if you want your limited company contracting career to be sustainable, writes chartered accountant Graham Jenner, founder of Jenner & Co.

Budgeting for VAT

If your company is registered for Value Added Tax, you have to charge VAT of 20% on top of your fees. This is known as your ‘Output VAT.’ Every quarter (or month if you have opted for monthly VAT returns), this has to be accounted for and paid over to HMRC.

It is very easy to use this extra 20% to help with your cashflow, but it is best not to become reliant upon it.

The safest way to think of these monies from VAT is that it is not your money, and so, as soon as possible after receipt from your client, it is wise to transfer the VAT proportion of the invoice into a savings account. Then, when the VAT is due to HMRC, simply transfer the money from the savings account to the company’s current account.

There are two ways to account for VAT, either based on the date of the invoice or on when you receive payment for your invoice (known as ‘Cash Accounting’). Cash accounting means that you only pay over the VAT on invoices after they have been paid. Otherwise, you can end up having to pay over VAT on unpaid invoices. So, if you aren’t already on Cash Accounting, it might be worth looking into, especially if your clients are slow or erratic in paying you.

VAT that you pay on goods and services for your business (‘Input VAT’), can be offset against the amount you have to pay over.

To avoid building up surplus funds in the previously recommended savings account, when you make a payment for goods or services on which you can recover the VAT, you could transfer the VAT amount from the savings account to the current account.

Or, to avoid making a number of small transfers each time a payment is made, at the end of the quarter, when transferring the VAT from the savings account to the current account, transfer the whole amount of the Output VAT, which has the same net effect.

Budgeting for National Insurance and payroll tax

The typical method of extracting money from your own company as an IT contractor is to pay a small salary and take the rest of your income in the form of a dividend.

As a result, the amount of tax and national insurance to be paid over each month is often nil or a small amount.

Your accountant can advise how much to set aside. But if you are paid weekly, you could consider setting the tax and national insurance aside each week (again into a savings account), to be used after the end of the tax month, when the tax and NI is due.

If you have other income, this may affect how much tax you effectively pay on your salary from your company. If you are in this position, it is generally worth talking to your accountant, so that they can include that other income in the calculation of your overall tax liability.

Be aware, an accountant may suggest allocating your tax allowances in a particular way, or suggest setting aside, separately, a certain percentage of your other income. Either way, the aim will be to avoid unexpected lump sum payments of tax at the end of the year.

What about budgeting after a rate rise or fee increase? 

If you are lucky enough to secure an increase in your hourly/daily rate, you might want to re-assess the amount you set aside for tax – not only because the more income you have the more tax you will pay, but also because the effective tax rate may be higher.

For example, you could move from 20% basic rate tax (taxable income from £12,571 to £50,270) into the 40% higher rate tax bracket (taxable income from £50,271 to £125,140), or from the higher rate tax band to the 45% additional rate band on taxable income over £125,140. In addition, be aware when budgeting that you lose personal allowances of £1 for every £2 of income over £100,000.

If you are taking most of your income in the form of dividends, you will not actually ‘see’ the above rates, as the dividend tax rates take into account the fact that corporation tax is payable on the profits from which the dividend is paid.

Budgeting for dividend tax

If you are taking a proportion of your income as dividends, there is dividend tax to pay on any dividends in excess of £500 (for 2024-25).

Again, to budget for that, you could set aside 8.75% of any dividends you pay yourself from the company. To the extent that the dividends plus salary plus other income exceed £50,270, the amount to set aside for dividend tax is 33.75%, while above £125,140, it is 39.35%.

Speak to your accountant, for advice on how much more to set aside for dividend tax

Setting a budget for your corporation tax bill from HMRC

IT contractors typically incur relatively small amounts of costs in running their business, which makes calculating profit relatively easy.

Profit is the company’s income (net of VAT), less your salary, less Employer’s National Insurance (if any), less Employer’s pension contributions (if any), less other costs (net of VAT).

With this definition in mind, you can right now make a rough estimate of your profits on a weekly or monthly basis.

What about on annual basis? Well, the starting point is that if your profit for the year is less than £50,000 then corporation tax is 19%. Where profit is over £250,000, corporation tax is 25%, and between £50,000 and £250,000, marginal relief brings the effective rate down to somewhere between 19% and 25%.

Budgeting for corporation tax: three options

While this may sound complicated, there are a three main options when it comes to budgeting for corporation tax.

1. Work out the likely profit for the year. Set aside Corporation Tax based on the applicable corporation tax rate for that level of profit. Only amend the rate if something significant changes.

2. Set aside corporation tax based on 25% of the profit estimate each week or month. If the profit is less than £250,000, there will be spare money available for an additional dividend (or to be held in the company as a buffer).

3. If the company is on a fixed contract, and you are on a fixed salary, and other costs are fairly fixed, work out an amount to set aside each week or month – and simply stick with the fixed amount as a reasonable provision towards the corporation tax bill.

Important note

Corporation tax is, perhaps, the most important HMRC levy which limited company IT contractors have to budget for, as it is payable in one lump sum, nine months and one day after the end of your financial year.

This requirement can make it difficult to find the money to pay it if it isn’t budgeted for. It can also be tempting to ‘dip’ into any provision you have made!

Are IT labour market downturns worth factoring in to a limited company budget?

There may come a time when work is scarce or worse – there have been quite a few dips in demand for IT contractors in the last few months alone! There’s also seasonal dips in demand to be wary of, and these periods can make getting renewed or extended more important.

Setting aside funds to cover living costs during a period with little or no work is therefore worth considering. The extent to which you may wish to do so, will depend on your own outlook on life, however. And that might depend on your confidence to bounce back, make up for an under-earning quarter, or just continue to be able to secure work at market rate while maintaining a beady eye on tax-efficiency and allowable business expenses.

Budgeting to replace equipment and for IT training

The extent to which this is necessary will depend on the cost of replacing existing equipment, software, and any training that may be required to keep you up to speed and your tech skills in demand. Where this would prove difficult to meet out of normal cashflow, consider setting money aside based on the estimate of how much and when the investment will be needed.

Expert advice? It’s often only as good as the inputs

In the above I have tried to provide an indication of what a typical IT contractor should consider in the way of budgeting for tax and other costs.

Speak to your accountant for tailored guidance. Indeed, many accountants who specialise in dealing with contractors can readily provide a weekly or monthly statement of how much you should set aside and how much you can pay yourself. With a bespoke system such as the one which we ourselves have invested in, these statements can be tailored to your personal circumstances and adjusted accordingly.

And that brings me neatly on to my last but not least important budgeting point! If you are taking advice from an expert, do remember to tell them if your circumstances change.