PAYG instalments explained: how sole traders pre-pay income tax

What PAYG instalments are

Pay As You Go instalments are amounts you pay toward your expected income tax bill, usually every quarter. They are not an extra tax. When you lodge your return, every instalment you paid is credited against the tax assessed, and you pay the balance or receive a refund. The point is to avoid a single large bill in October and to give the ATO a steadier flow.

They are separate from PAYG withholding, which is tax taken from employees’ wages. As a sole trader with no staff you will only ever see instalments.

How you get entered

The ATO enters you automatically after you lodge a tax return showing business or investment income above its thresholds and a resulting tax liability above a set amount. You receive a letter or a message in myGov explaining that you are now in the system and how much your first instalment will be. There is no form to fill in and no way to opt out while you meet the criteria, though you can vary the amount.

The first instalment usually lands on the next activity statement after the letter, which for many people is a surprise line on a BAS they thought was only about GST.

Option 1 or option 2

You choose how the instalment is calculated:

• Option 1, instalment amount. The ATO works out a fixed dollar amount from your last return, adjusted for expected growth, and pre-fills it. You pay that each quarter. Simple and predictable.
• Option 2, instalment rate. The ATO gives you a percentage. Each quarter you multiply your actual instalment income (your gross business income for the quarter, not profit) by that rate and pay the result. This tracks your real income up and down, which suits seasonal or lumpy businesses.

You pick on the first statement and can change annually. Option 1 suits steady income; option 2 suits a business whose income swings.

Where it appears and when it is due

If you are registered for GST, the instalment sits on your BAS: label T7 for option 1, or T1 and T2 for option 2, with the result at 5A. If you are not registered for GST, you receive a separate instalment activity statement with just the PAYG section.

Quarterly instalments are due on the BAS dates: 28 October, 28 February, 28 April and 28 July. Some sole traders with smaller liabilities are offered an annual instalment instead, due after the end of the financial year. The ATO tells you if you are eligible.

Varying the instalment

If your income has dropped, you can vary the instalment amount or rate downwards on the statement. If it has risen, you can vary upwards to avoid a big balance later.

Be careful varying down. If your varied instalments end up at less than 85% of the tax you actually owe for the year, the ATO can charge interest on the shortfall. Vary when you have a real reason, such as losing a major client, and keep a note of why.

The first-year trap

In your first year of business there are no instalments, because the ATO has no return to base them on. You lodge that first return, pay the full year’s tax in one go, and at the same time the ATO enters you into instalments for the year already under way, which may include a catch-up. Two years of tax can feel like they arrive within a few months.

The fix is to set money aside from the start as if instalments already applied. See setting aside money for tax for a simple method, and our sole trader tax calculator for a rough figure.

Keeping it tidy

Record each instalment paid; it is not a deductible expense but it is a credit you want to see on your assessment. Categorise it separately from GST so the two do not blur. And review the amount each July: if your income has changed a lot, adjust early in the year rather than at the fourth quarter.