How much income should I put aside for holidays and sickness?
Quite apart from the fact that contractors may have irregular income or, indeed, long periods without any earnings, they also need to make provision for holidays and periods of illness, writes Graham Jenner, founder of contractor accountants Jenner & Co.
Some contractors will be in the lucky position that they can work extra hours, either side of a holiday to compensate for the lack of income in the holiday period. But there is no guarantee of this, nor might the contractor want to do so.
Setting aside money to cover for holidays – as a limited company contractor
So, how much should be set aside to cover holidays, bearing in mind that the amount ought to ideally cover bills, and other fixed costs, in a period when there is no income?
Simplest method? Take a fixed amount from the company each week or month
The limited company (or PSC) contractor could estimate the total amount of income that they will take from the company during the year, bearing in mind periods of no work for holidays, sickness and the like. If that figure is then divided by 12, the company could then pay the resulting amount each month (or divide the income by 52 and take the resulting amount each week).
This puts the contractor in a similar position as a salaried employee, receiving a fixed amount per month irrespective of whether they work a full month/week.
It is prudent to understate the total amount of income, particularly where any amount over and above the prudent amount would result in higher rate tax.
Extra profits can be taken later as a ‘bonus’ dividend, should the company have the available profit after tax.
What about the dividend-salary mix?
But isn't this complicated by the fact that PSC contractors generally take a small salary and the rest of their income as a dividend?
The fact that part of the income is paid as a dividend doesn't really matter. Your accountant will advise on the documentation surrounding this.
Budgeting by the individual
The above is the simplest form of dealing with payment for holiday periods for the individual director of a limited company. You don’t need to budget for the fact that the company has no income during the holiday period, as you are receiving the same income, each week or month.
However, for those who prefer to take the available income from the company when it is there, it is prudent for the individual to set money aside, personally, to cover the living costs for periods when the company cannot pay them.
Many contractors simply put aside a sum of money, either a percentage or a fixed amount, into a savings account on a regular basis. They may not even think of this, particularly, in terms of setting money aside for holiday and sickness, but just generally for times when there is no income, given the unpredictably of contracting and potential irregularity of income.
Is there a formula for how much money to set aside for holiday?
Any formula to calculate holiday pay depends on how much holiday the contractor will take in the year.
If you took no holiday, and worked 52 weeks, including bank holidays, then you wouldn’t need to set aside anything.
If you want to take three months’ holiday all in one go and work the other nine months of the year without any break, then you should set aside in the nine months the amount needed to cover living costs for the three months (unless you intend living of savings for the three months).
Those two examples are perhaps extreme, but they demonstrate the concept.
For those who like the reliable crunch of numbers, the formula for setting aside a fixed sum to cover living costs during periods of holiday is as follows:
H/(52-H) X M = amount to set aside per week worked
Where H = total amount of intended holiday in the year in weeks and M = money required per week (to live on)
Living costs £800 pw, anticipated holiday 4 weeks.
Applying the formula:
4/(52-4) x 800 = £66.67pw to set aside. Proof: £66.67 x 48 wks = £3,200 being 4 wks at £800pw
Of course, there is still the need to make provision for the total cost of the holiday (but it is assumed that that is budgeted within the living costs figure)
If a contractor requires the same average amount of income during periods of holiday, then the above formula becomes:
NA - NA/52xH
Where NA = Net Available income for any particular period, and H = the number of expected weeks holiday.
Anticipated holiday 4 weeks.
Net Available income in the week in question is £1,000.
Applying the formula:
1000x H/52 = £76.92 to set aside for that week. Proof: If net available is £1,000 pw for the 48 weeks worked, income after set aside is £ £923.08. Set aside will be £76.92 x 48 weeks = £3,692.16 being 4 weeks at £923.08pw (though in practice income will vary and so will set aside).
What about setting aside cash for bouts of illness?
Making provision for periods of sickness for minor illness is really just a matter of guesstimating the number of days that you may not be able to work in a year through sickness and treating that estimate as additional holiday within the above formulae.
What about longer term or more serious sickness?
Due to the unpredictable nature of longer term and/or serious sickness, making provision on a weekly or monthly basis is less easy to budget for. It can be incorporated within a general savings set aside i.e. putting money aside for when there is no work, whether through holiday sickness or simply not having a contract.
Contractors might consider taking out income protection insurance. It's an insurance policy that pays out a monthly amount (not necessarily the amount of your full income) if you’re too ill or injured to work.
But income protection insurance only pays out when you can’t work for medical reasons, so it won’t pay out just because you have no work. Depending on the policy you take out, it may pay for a fixed period or for the duration of the period for which you are unable to work due to the illness or injury. It is important to understand what you are and are not covered for, so read your policy’s small print.
What about working through an umbrella company, in terms of holiday and illness?
Many contractors who have, or previously had, their own company, will find that they may need to be paid through an umbrella company for certain contracts.
If you work for an umbrella company, holiday pay should be accounted for when you are paid. You may see a figure of 12.07% being used (which is based on the standard 5.6 weeks holiday).
Holiday may be ‘retained’ (by the umbrella company) or ‘rolled up.’
If the holiday pay is retained by the umbrella company, it is available to be paid to you when you are on holiday. Check with your umbrella company, what they require from you as notification that you are taking holiday, in order to be paid.
If the holiday pay is ‘rolled up’ it is paid at the same time as your normal pay, and will be shown as an advance of holiday pay, or similar. This means that you receive your holiday pay, rolled up into your payments each week or month – and will not be paid when you take holiday. So you will need to set money aside based on the advance, much as noted above under 'Budgeting by the individual.'
The figure shown as an advance will be a gross figure, so the amount you set aside does not need to be as much as that. A simple rule of thumb would be to set aside, each pay period, the proportion of net pay that the advance represents as a proportion of the total gross pay.
This obviously only covers holiday pay, so you might still want to budget for periods of sickness, separately, again using an educated guestimate, perhaps on how many sick days you took in the last 12 months.
For those new to contracting, hopefully, this article will help clarify the question of how contractors could make provision for holidays and sickness – even if there are only formulas rather than ‘hard and fast’ rules. For others, it may just be a timely reminder not to overlook this important element of contracting.