PAYE vs. Umbrella – Which is Best for You?

The question of PAYE vs. Umbrella is one asked by many contractors and freelancers throughout their careers. To help answer this question, Umbrella Options has created a guide to ensure you make the most cost and time-effective choice and have the best result for your bank account.

What is pay-as-you-earn (PAYE)?

Pay-as-you-earn is the standard form of income tax in the UK, which refers to your tax and National Insurance obligations being deducted from your salary before it is paid to you. Student loans can also be repaid through pay-as-you-earn. This is in contrast to filing tax returns, where you would be required to pay your obligations every year, quarter, or month, rather than having the deductions made at source.

For most full-time and part-time employees, PAYE is the go-to tax and National Insurance payment method. Contractors and freelancers typically use another method, as they are not the direct employees of the companies they work for and therefore are not on the payroll.

Tax rates under PAYE

Tax rates under the PAYE system vary throughout the UK. For England, Wales, and Northern Ireland, the PAYE tax rates are the same. For Scotland, however, there are a few slight differences.

PAYE Tax rates for England, Wales, and Northern Ireland

PAYE tax thresholds can change from year to year, with a small upcoming change for the year 2021-2022. The personal allowance refers to an amount you can earn each year without it being subject to taxes. Any earnings above this allowance will be taxed according to its bracket.

For 2020-2021:

• Tax-free personal allowance – £0 to £12,500 per year
• Basic rate (20%) – £12,501 to £50,000 per year
• Higher rate (40%) – £50,001 to £150,000 per year
• Additional rate (45%) – £150,001 and above per year

For 2021-2022:

• Tax-free personal allowance – £0 to £12,570 per year
• Basic rate (20%) – £12,571 – £50,270 per year
• Higher rate (40%) – £50,271 to £150,000
• Additional rate (45%) – £150,001 and above per year

PAYE Tax rates for Scotland

The PAYE system applies a little differently to Scotland, with additional brackets to be aware of.

For 2020-2021:

• Tax-free personal allowance – £0 to £12,500 per year
• Starter rate (19%) – £12,501 to £14,585 per year
• Scottish basic rate (20%) – £14,586 to £25,158 per year
• Intermediate rate (21%) – £25,159 to £43,430 per year
• Higher rate (41%) – £43,431 to £150,000 per year
• Top rate (46%) – More than £150,000 per year

For 2021-2022:

• Tax-free personal allowance – £0 to £12,570 per year
• Starter rate (19%) – £12,570 – £14,667 per year
• Scottish basic rate (20%) – £14,667 to £25,296 per year
• Intermediate rate (21%) – £25,296 to £43,662 per year
• Higher rate (41%) – £43,662 to £150,000 per year
• Top rate (46%) – More than £150,000 per year

A commonly held belief is that your income is taxed at a single rate, with your earnings bracket determining the percentage income tax rate applied to your entire income. This is not true. Rather than a flat percentage, you will only pay taxes on the amounts within each bracket. For example, if you were to earn £120,000 per year, you would still receive the tax-free personal allowance of £12,500. The rest of your income between the basic and higher rates will be taxed at 20% and 40% respectively.

PAYE agencies vs. Umbrella companies

Whether you choose to work with a PAYE agency or an umbrella company, you will still pay the same taxes, as both options fall under the PAYE tax system. This begs the question – what is the difference between the two?

When contracting through a PAYE agency or an umbrella company, you will work as an employee and be added to the payroll of your chosen organisation, subjecting your income to tax under the PAYE system. Although this is the same regardless of your choice, there are some key differences between PAYE agencies and umbrella companies which may be make-or-break.

Although you will be classed as an employee regardless of your choice, there is a considerable difference between the two. With a PAYE agency, you will have your salary processed as usual, however, they decide your contracts and work hours, not you. With an umbrella company, contractors are free to determine their own contracts and work hours, affording contractors the freedom to work as much or as little as they like.

As you will be considered an employee with both PAYE agencies and umbrella companies, you will be eligible for the same statutory benefits and payments as salaried employees. This includes sick pay, maternity or paternity pay, holiday pay, and so on. Salaried employees also benefit from the security of continuous employment, making things easier when applying for loans or mortgages. When working with an umbrella company, you will receive a tax code that allows you to benefit from the same continuous employment status as salaried employees. PAYE agencies do not hand out tax codes, meaning contractors working with them may have more difficulty.

Limited companies and self-assessment

Another option open to contractors is forming a limited company and contracting through it. Compared to PAYE, there is no difference in tax rates – you will still receive the tax-free personal allowance, then have your earnings taxed according to the basic, higher, and additional tax rates. The noteworthy difference here is how the tax payment works.

Using PAYE, your tax is paid at source, meaning the appropriate tax deductions are made before you receive your earnings, with nothing further required on your end. Through a limited company, however, you will need to file a self-assessment tax return every year, quarter, or month depending on your circumstances. As you might expect, this can involve a series of headache-inducing tax calculations and forms, which is why it is common for contractors to hire an accountant if they pay taxes through self-assessment.

An additional noteworthy difference between limited companies and PAYE options is that you are classed as a director, not an employee. This means that unlike with PAYE agencies and umbrella companies, you will not be eligible for statutory benefits. You will have to bear the costs of taking a holiday or a sick day yourself.

Which is best for you?

When deciding which method of contracting to use, it can be easy to fixate on the one that makes you the most money. This is important, of course, but as all three options fall under the same tax rates, it can be best to consider how each option fits your situation.

If you would prefer a more secure form of contracting, then working with an umbrella company or a PAYE agency could be best for you. With these options, you will have much of your administration handled for you, your taxes will be processed through PAYE, and you will have the security of statutory benefits. For contractors looking to get started or just test the waters, these two options could be better for you than a limited company, though keep in mind that working with a PAYE agency will leave you with very little choice in when you work and what you work on.

For contractors who prefer to have complete control over their work, forming a limited company could be best. You will be responsible for filing your own tax returns, sourcing your own contracts, and handling the day-to-day administration of running a company. In exchange for increased responsibilities, you will have significantly more freedom in how and when you work.

Are there additional costs to consider?

Another factor to consider when making a choice is hidden or additional costs. When working with an umbrella company or a PAYE agency, you will pay them a fee for their services, in addition to accessing any benefits they might offer. This fee includes putting you on their payroll, handling your administration, liaising with clients, calculating your tax and National Insurance contributions, and in some cases, giving you the means to claim back expenses incurred during your contract work. The fee you pay is deducted before tax calculations are made, meaning you can recover a portion of this cost by paying a little less in tax. This fee will be paid either monthly or weekly, but it typically works out to £15 per week. Assuming you work with a good, compliant umbrella company, the service rendered can definitely be worth it.

Working through a limited company, however, does not require any additional costs excluding startup costs, provided you manage your own administration and taxes rather than hiring any assistance. If you make regular use of accountants, you could end up paying more than the cost of using an umbrella company or PAYE agency for a service that is functionally the same. Alternatively, you may find that the time you spend handling your taxes and administration could be better spent on contracting, though this is dependent on you and your situation.

Finding umbrella providers

Working with an umbrella company can provide contractors with a perfect blend of the freedom offered by a limited company, along with the security offered by PAYE agencies. Due to this, the popularity of umbrella companies has seen a rapid increase across the UK, with each company claiming to be the best. If you want to know what your umbrella company can do for your payslip, use Umbrella Options’ take home calculation to find out.