Pay-as-you-earn (PAYE) vs umbrella company – it’s a choice faced by thousands of contractors across the UK. At Umbrella Broker, we want to focus on what’s best for you – and for many, it comes down to which is most cost and time-effective.

In this post, we’ll discuss the pros and cons of PAYE vs umbrella companies and which is best to maximise your take home pay.

What exactly is PAYE?

Pay-as-you-earn (PAYE) refers to the standard form of income tax in the UK. Tax (and national insurance) is deducted from your salary before it is transferred to you. It differs from a tax return, where individuals or businesses pay their tax annually, quarterly or monthly after they have processed income and other outgoings.

PAYE is by far the most common form of taxation. Most full-time and part-time employees taxed use the system. The exceptions? People who are paid off-payroll, working for someone as a self-employed contractor or consultant. They provide their services on a non-permanent basis. This is why they’re not added to that company’s payroll and not classed as an employee.

PAYE tax rates

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

Despite common misconceptions, you aren’t taxed at a certain rate for your entire income. Instead, anything you earn up to £12,500 will be tax-free. Anything you earn between £12,501 and £50,000 will be taxed at 20% – and so on. So, someone earning £200,000 in a year will still receive the same tax-free allowance as someone earning £20,000.

These allowances and tax rates are worked out monthly. So, you could be taxed at a higher rate one month and then refunded at a later date if your annual income falls due to taking on a lower-paying contract and therefore falling into a lower tax band

PAYE vs umbrella

That’s how much tax you will pay through the PAYE system under both an umbrella company and PAYE agency, so if the amount of tax you pay is the same, what exactly is the difference between the two options?

Although both a PAYE agency and umbrella company will hire the contractor as an employee, adding them to their payroll and processing their income using PAYE taxation, the main difference between the two is who you choose to process your income through.

If you choose a PAYE agency, you will work through them and be employed by them. As a result, they will process your salary through their payroll as PAYE. However, they will also determine which contracts you take on and when you work.

An umbrella company will also employ the contractor, put them on their payroll and process their salary through PAYE. The main difference here, however, is that under an umbrella company, contractors have the freedom and flexibility to choose which contracts they work on and when.

With both PAYE and umbrella, contractors are considered employees, meaning they will receive statutory benefits such as sick pay, holiday pay and maternity/paternity leave.

However, a further difference between the two options is continuity of employment. Whereas an umbrella company offers contractors one handy tax code, PAYE agencies do not. This means the contractor can run into trouble when applying for a loan or mortgage.

Those are the main differences between PAYE and umbrella, but there is also a third option.

PAYE vs self-assessment

It’s also worth considering the option of self-assessment. When it comes to PAYE vs self-assessment, there’s actually no difference in income tax rates. Both use the same rates (personal allowance, basic rate, higher rate, additional rate).

The difference comes in how and when this tax is paid. While PAYE is paid before you get your wages – as you earn – a self-assessment tax return requires you to pay the tax you owe for a given period, whether it’s a month, quarter or year. This means the contractor will first be paid by the client and then must work out how much tax and National Insurance is owed and file this themselves.

This can often be complex, with tricky tax calculations involved, meaning a lot of self-assessment workers use the services of an accountant to take on the hard work for them.

Another main difference with the self-assessment route is that, unlike with both the PAYE and umbrella options, contractors operating under a limited company do not receive statutory benefits as they are not employed. This means if you wish to take a holiday or fall ill unexpectedly, you will have to cover the costs out of your own pocket and account for this in your contractor fee.

Those are the 3 main options, so which should you go for? When making the decision, many contractors look to which is the most cost-effective option.

Which is most cost-effective?

Because each option uses the same tax-rates, when making the decision between PAYE vs umbrella vs self-assessment, you shouldn’t focus on which is more cost-effective. Instead, it’s more important to consider which is the best fit for you and your contracting needs.

If you’re looking for complete independence to source and negotiate contract work, file your own tax-returns and run your own company, then setting up a limited company and paying tax through self-assessment is the best option for you.

On the other hand, if you’d prefer to have your contract work sourced and secured for you, not having a say in what projects you work on, and paying tax through the PAYE system, then a PAYE agency may be the best route forward.

However, if you are looking for a middle ground between these two options, then operating through an umbrella company could be the best option for you.

With an umbrella company, you have the freedom to choose which contracts you work on and when, combined with the security of being employed by the company and therefore being paid and taxed through the PAYE system and receiving statutory rights like an employee.

Many contractors turn to the umbrella option as it combines the best of both worlds. However, before you make the decision, it is also worth noting that there are further indirect costs associated with each option:

Indirect Costs

When it comes to indirect costs, both umbrella companies and PAYE agencies charge the contractor a fee in exchange for the range of benefits they offer, including putting them on the payroll, working out and deducting their tax and National Insurance contributions, giving them statutory benefits, filing and chasing invoices and in the case of umbrella companies, allowing them to claim back legitimate business expenses.

This fee is deducted before tax is processed, and is usually around £15 per week. Many contractors find this a fair price to pay for the level of service they receive in return.

On the other hand, with the option of self-assessment, although there is no fee to pay, these contractors usually end up paying for an accountant to help them with complex tax returns. The costs of an accountant can add up if this becomes a recurring expense.

It is also worth noting that it can be much more difficult to manage your income when you’re working on a quarterly or yearly basis, as you have to keep track of what you owe and be prepared to pay a lump sum to HMRC when the time comes to pay your taxes. This requires a lot of self-control and forward planning, as you will need to put funds to one side as you go.

That’s why many contractors take the umbrella route. If you have decided this is the best choice for you, the next step is to find the best umbrella company to work with.

Find the best umbrella PAYE provider

Working through an umbrella company is a beneficial option for contractors in all kinds of roles and sectors. Combining the freedom of being self-employed, with the security of receiving a salary, paying tax through the PAYE system and receiving statutory benefits, it’s an increasingly popular option for contractors.

But as more and more contractors have opted to take this route, the number of umbrella companies out there have soared too. With every umbrella company claiming to be the best, it’s important to compare companies and find the most suitable one for you.