During the current COVID-19 pandemic, many industries are experiencing booms and busts, with some certain industries facing strong demand for more, short-term workers and skill-sets.

This opens up great opportunities for contractors with project experience and transferable skill sets, however, many contractors will currently be asking what the best way for them to operate at this time is, whether that’s PAYE or umbrella.

To help contractors decide which route is the best option for them, Umbrella Broker explain how the PAYE and umbrella routes differ, looking at the PAYE vs umbrella options in detail to help every contractor choose the most cost and time-efficient contracting option for them.

Option 1 – PAYE explained

PAYE, or pay-as-you-earn, references the standard form of income tax in the UK. Under this system, both tax and National Insurance contributions are deducted from your salary before it is paid to you. This is the most common form of taxation, with most full and part-time employees paying tax this way.

The exceptions are for workers who are paid off-payroll. This applies to workers who operate as self-employed contractors or consultants offering their services on a temporary basis, meaning they are not added to the company’s payroll.

For the tax year April 2020 – April 2021, the PAYE system in England and Northern Ireland is based on the following tax bands:

• 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

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Option 2 – Umbrella companies explained

When looking at a PAYE vs umbrella comparison, it’s important to establish that technically, umbrella companies don’t differ from PAYE. Umbrella companies hire contractors as employees, putting them on their payrolls and processing their income and tax using the PAYE system.

The difference is who contractors choose to process their PAYE income through – contractors can either choose between agency PAYE or umbrella company PAYE.

Through the agency option, contractors will work through the agency and be employed by them. The agency will process the contractor’s salary through their payroll using the PAYE system. The key thing with agencies is that they will decide which jobs the contractor works on and when.

The difference between PAYE vs umbrella is that the umbrella option allows contractors to operate with a greater degree of freedom, letting them choose which contracts they work on and when.

With this option, contractors essentially mix the benefits of being self-employed, having the freedom to decide which projects to work on, with the benefits of being employed, as they do not have to complete a tax return, do business admin and receive statutory rights.

Option 3 – Self-assessment explained

There’s also a third route under which contractors can operate as limited company contractors where they pay tax on a self-assessment basis.

Contractors will still pay the same tax rates, the difference is how and when they pay their tax contributions. While under the PAYE system contractors’ tax contributions are paid and taken off their wages as they earn, with self-assessment contractors will first be paid, and then required to work out how much tax they owe for a particular time period which can be monthly, quarterly or annually.

PAYE vs Umbrella – what is the best option for contractors?

With this in mind, when it comes to considering making the decision between PAYE vs umbrella, it is important to work out which options works best for you as a contractor.

In terms of which option is most cost effective, whether a contractor operates via PAYE or an umbrella company, they will actually pay the same amount of tax whatever route they take. This usually means the financial aspect of PAYE vs umbrella shouldn’t impact a contractors’ decision.

The question all contractors should ask when it comes to choosing between PAYE vs umbrella is the degree of freedom and flexibility they require.

For those seeking contractor jobs with complete freedom, operating under a limited company and paying tax on a self-assessment basis may be the best option. However, it is worth considering that this option comes with the responsibility of working out and filing a tax return as well as the admin and paperwork that comes with running your own business.

The easiest option may be working through an agency who finds the contractor jobs and pays their salary through PAYE. However, this option comes with the drawback that contractors will not be able to choose which projects they work on and when.

The third option is operating through an umbrella company. For many contractors, this offers the best of both worlds, giving contractors complete freedom to choose which projects they work on, without having to do the tricky calculations that come with filing a self-assessment tax return.