PAYE vs umbrella is an age-old choice faced by thousands of contractors. When it comes to deciding between the two options, contractors need to consider what’s best for them. For many, this boils down to which is most effective in terms of time and money.

In this guide, Umbrella Broker look at the differences between PAYE and umbrella, exploring the pros and cons of each, to help every contractor choose the best option for their needs.

Pay-as-you-earn (PAYE)

The first option for contractors is PAYE, or pay-as-you-earn. Many contractors will be familiar with PAYE as the predominant and most common form of taxation in the UK.

With the PAYE option, a contractor’s tax and National Insurance contributions are taken from their salary before it is paid to them. Most payroll workers are paid through the PAYE system. The exception lies with the self-employed who are not put on a company’s payroll and are therefore responsible for carrying out self-assessment.

Under the PAYE system, contractors will be taxed in line with current tax bands, working through a PAYE agency who will source and find them contracts to work on.

Tax bands are subject to change and vary from country to country within the UK.

The 2020 – 2021 tax bands in England are as follows:

• Tax free Personal allowance: up to £12,500 per year
• Basic rate (20%): £12,501 – £37,500 per year
• Higher rate (40%): £37,501 – £150,000 per year
• Additional rate (45%): over £150,000 per year

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

• Tax free Personal allowance: up to £12,500 per year
• Starter rate (19%): £12,501 – £14,585 per year
• Basic rate (20%): £14,586 – 25,158 per year
• Intermediate rate (21%): £43,431 – £150,000 per year
• Top rate (46%): over £150,000 per 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

Umbrella companies

When it comes to deciding between PAYE vs umbrella, many contractors face confusion due to the fact that the two do not technically differ in terms of how and how much tax a contractor pays. Just like with the PAYE option, an umbrella company will take on the contractor as an employee, put them on their payroll and tax them using the PAYE system.

The main difference between PAYE and umbrella is between who the contractor chooses to operate under which impacts how they contract. There are pros and cons to each option which we will explore after looking at the third way of contracting.

Limited companies

It’s important to remember that there is a third option for contractors. This revolves around contractors being self-employed and operating under a limited company.

With this option, contractors will not be put onto a company or agencies’ payroll and will instead be responsible for carrying out self-assessment and making their own tax and National Insurance contributions once they have been paid their contractor fee.

This option was once considered the most tax-efficient way, however, with the upcoming changes to IR35 legislation, many contractors are avoiding this route, instead choosing to be employed by an agency or company in order to be IR35 compliant.

PAYE pros and cons:

Now you know all your contracting options, it’s time to look at the pros and cons of PAYE vs umbrella to help you make the best decision.

The pros and cons of a PAYE include:

• Pros: an agency PAYE is easy to join and will entitle contractors to statutory employee benefits such as holiday and sick pay.
• Cons: contractors working under a PAYE agency cannot usually claim back legitimate business expenses, they are typically not offered continuity of employment meaning one handy tax code and finally, they cannot choose which contracts they work on and when.

Umbrella pros and cons:

On the other hand, the pros and cons of the umbrella option are as follows:

• Pros: umbrella companies are quick and easy to join. They entitle contractors to statutory benefits enjoyed by employees such as holiday and sick pay, they allow contractors to choose which contracts they work on and when, they let contractors claim legitimate business expenses which can then be offset against tax and finally they offer contractors continuity of employment meaning one handy tax code.
• Cons: some contractors do not want the freedom the choose their own contracts and would rather this task was taken from them.

Umbrella vs PAYE: which is the best option for contractors?

Looking at both the pros and cons of each option, contractors can make a well-educated, informed decision about the best route forward for them.

It’s important to remember that with both options contractors will pay the same levels of tax. However, with the ability to claim business expenses, have just one tax code and the freedom and flexibility to choose the contracts they work on, many contractors find that the best route forward is to go with an umbrella company.

Lots of contractors choose this route to couple the security and stability of being employed with the benefits of self-employment in being able to choose what projects they work on and when.

If this sounds like the best path for you, the next step is to find the best umbrella company for your needs.