One of the biggest decisions faced by contractors is how they will operate, whether that’s through an umbrella company or a PAYE agency.

There are many factors to take into consideration when making the choice and therefore it’s not a decision that should be taken lightly. That’s why it’s important to look at what each option involves and how this will impact you as a contractor.

To help contractors make the all-important decision, Umbrella Broker explains what a PAYE agency is and how it compares to an umbrella company, so you can make the right choice for your contracting needs heading into 2021.

What is a PAYE agency?

A PAYE agency employs a contractor, therefore paying them a salary and processing and deducting their tax through pay-as-you-earn (PAYE.)

PAYE simply refers to the most common form of taxation in the UK, with most full-time and part-time employees paying tax in this way. The only workers that won’t pay tax under this system are those that are paid off-payroll, such as the self-employed.

A PAYE agency will secure work for the contractor, meaning they have no say about which contracts they take on and when. Whenever the contractor takes on a new contract, they are given a new tax code and term of employment.

As an employee of the PAYE agency, the contractor is entitled to statutory benefits enjoyed by employees in the UK, from holiday pay, sick pay, maternity or paternity leave to a workplace pension. 

That’s what a PAYE is, now let’s look at the other option.

What is an umbrella company?

The other option for contractors is an umbrella company. Like a PAYE agency, an umbrella company also employs the contractor and therefore pays them a salary and processes and deducts their tax through the PAYE system. As an employee of the umbrella company, the contractor also qualifies for statutory benefits.

Although a PAYE agency and umbrella company are similar in these respects, there are some key differences between the two.

 Unlike a PAYE agency, an umbrella company allows the contractor to choose their own contract work, giving them a greater degree of freedom and flexibility. This is great for those contractors that want to be in charge of their career development.

Another main difference is that an umbrella company offers contractors one handy tax code and continuity of employment. This is always useful for those looking to get a mortgage or loan.

What are the current PAYE tax bands?

Whether you work under a PAYE agency or umbrella company, you will be subject to the same levels of tax according to PAYE tax rates which are as follows:

For April 2020 – April 2021, the PAYE system in the UK uses the following tax rates, based on your annual income:

• Personal allowance (tax-free) – Up to £12,500 a year
• Basic rate (20%) – £12,501 to £50,000 a year
• Higher rate (40%) – £50,001 to £150,000 a year
• Additional rate (45%) – More than £150,000 a year

If you live in Scotland, the income tax rates are slightly different as follows:

• Personal allowance (tax-free) – Up to £12,500 a year
• Starter rate (19%) – £12,501 to £514,585 a year
• Basic rate (20%) – £14,586 to £25,158 a year
• Intermediate rate (21%) –£25,159 to £43,430 a year
• Higher rate (41%) – £43,431 to £150,000 a year
• Top rate (46%) – more than £150,000 a year

The PAYE system in Wales is based on the following tax bands:

• Tax-free Personal allowance: up to £12,500 per year
• Basic rate (20%): £12,501 – £50,000 per year
• Higher rate (40%): £50,001 – £150,000 per year
• Additional rate (45%): over £150,000 per year

PAYE vs Umbrella vs Limited Company: the third option

As well as PAYE vs umbrella, it is also worth considering that there is a third option, setting up a limited company.

Here, the contractor sets up their own limited company and is therefore self-employed. The contractor must take on the duties of running a business, including the admin and paperwork associated with this, source their own contracts, invoice the client, chasing up any late payments, and finally they must pay tax through self-assessment.

Although the contractor will still pay the same amount of tax in line with PAYE tax bands, rather than paying it as they earn and having what is owed deducted from their wages, the contractor pays it every quarter or year. This means that the contractor is first paid by the client and must then work out how much tax and National Insurance is owed and file this themselves.

This is often complex and complicated meaning many limited company contractors opt to use the services of an accountant to help.

Another difference when operating through a limited company is that it means the contractor will not receive statutory benefits like an umbrella or PAYE contractor. As a self-employed worker, the contractor is responsible for covering the costs if they wish to take time off for a holiday or fall ill and cannot work.

Which route is best for me?

Now you know the key differences between a limited company, PAYE and umbrella, it’s time to choose the best path for you.

Many look to make a decision based on which will be the most cost-effective. However, as each option uses the same tax-bands, instead of looking at cost, it is more useful to consider which option will best suit your contracting needs.

For contractors looking for total independence, who are willing to take on the duties of running their own business, negotiate their own contract work and file for self-assessment, then a limited company could be the best option.

However, it is worth noting that from April 2021, big changes to IR35 will see thousands of limited company contractors badly impacted, meaning many of these contractors are considering moving towards an umbrella company or PAYE agency instead.

For contractors that want to have their work secured for them and don’t want a say in what contracts they work on, then the PAYE option could be the best fit.

However, if you are looking for the freedom to find your own contracts and therefore enjoy the flexibility of the contracting lifestyle, coupled with the security of employment, then the umbrella option is the best route.