Millions of self assessment taxpayers are being encouraged to pay their tax in advance by the Government. However, you could be missing out on hundreds of pounds in interest via this option.

HM Revenue and Customs (HMRC) currently pays no interest on the vast majority of income tax payments made in advance.

Yet HMRC is currently writing to almost six million self assessment payers, who are registered online, asking them to spread their payments over the year under a new direct debit (DD) scheme. This means much of their tax liability will be paid early.

Instead, you're best off putting the cash in a savings account or in an offset mortgage account, if you have one (see the Top Savings Accounts guide). Then, pay your tax from that account as close to the deadline as possible.

Most self assessment taxpayers only have to make payments twice a year, on the strict 31 January and 31 July deadlines. The new DD payment scheme, however, is purely voluntary. It has been in place over recent months as a trial, but the current campaign represents the main roll-out.

0% interest

The new service comes just a few months after the Government ceased all interest payments on tax paid in advance, even though the official Bank of England base rate is still positive, albeit at an historic 0.5% low. The rate paid dropped from a miniscule 0.75% to 0% in January.

Yet even when the official Bank of England borrowing rate stood at 5% this time last year, HMRC only paid 3% interest.

If you pay in advance by specifically buying a tax certificate you can get paid up to a paltry 0.75% interest but to earn anything you must owe at least £100,000 in tax, which is out of the question for the vast majority.

While no interest is given to those who pay early, anyone who pays late, gets charged 2.5% interest, five times the 0.5% base rate.

Tony Tesciuba, from accountancy firm Tesciuba Limited, says: "If there is no interest paid then what is the point in using this scheme? If you want certainty then just pay by online banking or debit card.

"However you pay, always be careful to enter your reference number correctly."

The only time it's worth considering paying your tax early by direct debit is if you're bad with money and fear the tax deadlines will slip your mind.

How the scheme works

The Budget Payment Plan, as HMRC calls it, allows you to choose the frequency and payment amounts. You can also cancel payments at any time.

Any payments you make reduce the amount you're liable to pay on the 31 January and 31 July deadlines.

The only constraint, which applies to all self assessment taxpayers, is you must settle any balance owed by those dates.

As a rule of thumb, assuming your income this tax year (April to April) is roughly the same as last year, you pay half your tax at the end of January of this tax year, and the remainder at the end of the following July.

Why DD doesn't pay

Anyone who owes £10,000 in tax and national insurance in 2009/10 could earn approximately £130 interest after tax if they saved that cash in a typical 3% savings account and paid their tax bang on time. If you owe £20,000 you could earn over £200 interest.

This assumes you earn a steady income and you earn the same during the current financial year as in the previous 12 months, with nothing extra to pay after the 31 July payment.

What's more, given interest rates are low, your earnings are likely to double in future if typical savings rates reach last year's 6%-7% level again.

You could earn even more by being clever and fixing some of that cash for a year or putting some in a regular savings account (see the Fixed Savings and Regular Savings guides).

Further reading/Key Links

Top savings guide: Top Savings Accounts
Guide to fixing: Fixed Savings
MSE News (21.07.09): Beware the fake HMRC tax email