PAYE or Umbrella – What is the Most Cost-Effective Solution?

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Many contractors have to choose between opting for PAYE or an umbrella company. However, the aim is to understand what is right for them, and this is often based on the option that is both cost and time-effective. So, this article aims to cover the advantages and disadvantages of both PAYE and Umbrella companies and which one is the right option for enhancing your take-home pay.

PAYE – What is it?

The standard form of income tax in the UK is referred to as PAYE, and this involves tax being taken from your salary before you receive it. It is not like a tax return whereby tax is paid on an annual, quarterly, or monthly basis once the income has been processed, and it is the most common type of taxation. The majority of part-time and full-time employees who are taxed will use the system, although there are exceptions. This can include those who are a consultant, self-employed individuals and those who are paid off-payroll. All of the services provided by these are done so that it is not considered permanent and so, they are not added to the payroll of a company and are not considered an employee.

PAYE tax rates

For the tax year of April 2020 to April 2021, in the UK, the PAYE system will use these tax rates, which are determined by your annual salary:

  • 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 reside in Scotland, then you will have to use different tax rates, which include:

  • 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

In Wales, there is a PAYE system that uses these 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

However, there is a lot of incorrect information out there as many believe that you are taxed the same rate for all of your income, but this is incorrect. Up to the first £12,500 that you earn, you won’t be taxed. From £12,501 to £50,000, you will be taxed at a rate of 20% and even someone who is considered a high earner, with a salary of £150,000 as an example, they too, will have the same tax-free allowance as someone who earns £30,000.

The allowances and rates are calculated monthly, which means you could find that you are taxed at a higher rate one month. However, this will be repaid if the annual income drops due to working on a contract that is paid a lower rate and falls within the lower tax band.

PAYE vs. Umbrella

So, if you pay the same amount of tax under both a PAYE system and an umbrella company, what is the difference between the two?

While an umbrella company and a PAYE agency hire a contractor as an employee before adding them to their payroll and dealing with their income through PAYE taxation, the real difference is who you decide should process your income.

Opting for a PAYE agency will mean working through them, which means that they will take care of your salary via their payroll as PAYE. However, this will impact the contracts that you can agree to and when you choose to work. 

A contractor will also be an umbrella company employee, which means that they will be added to their payroll and have their salary paid through PAYE. However, the main difference is that the umbrella company will give the contractor the ability to decide which contracts they can work on and when they choose to work.

Contractors are considered employees through both options, and that means that they are entitled to the same benefits that usual employees receive, such as holiday pay and sick pay. Despite this, continuity of employment is another difference between the two, and an umbrella company will give contractors a single tax code, whereas PAYE agencies will not do this. Therefore, the contractor could experience significant problems when deciding to apply for a mortgage or a loan. While these are the main differences between the two, there is another option.

PAYE vs. Self-assessment

Self-assessment is also an option that is worth considering. There is no difference between self-assessment and PAYE regarding income tax rates as the same rates are used, such as personal allowance, basic rate, higher rate, and additional rate. The real difference comes down to when you have to pay the tax. In terms of PAYE, this is paid before you receive your payment and as you earn, but self-assessment requires tax to be paid on either a monthly, quarterly or annual basis. Therefore, a contractor will receive their client’s pay before determining how much tax and National insurance has to be paid before filing it.

Tax calculations can prove challenging and complex, and that’s why many self-assessment individuals will opt to use an accountant. Another significant difference compared to both PAYE and umbrella companies is that self-assessment doesn’t come with the statutory benefits. If they fall ill or want to take a holiday, they will not get paid.

With these three options in mind, which one should you choose? When it comes to making their choice, many contractors will opt for the one that is cost-beneficial. 

Which Option is the Most Cost-Effective?

As all three options follow identical tax rates, when you choose which one is right for you, it’s important to try and not focus on the most cost-effective option. Instead, it would help if you thought about which one fits your needs. 

If you want to work independently while seeking work and negotiating contracts while taking care of tax and running your own business, then a limited company is the best choice. This will mean that you pay tax via self-assessment and is likely to be the best option for you.

However, if you want the process of sourcing work taken care of while not having any input into the projects you undertake, with tax paid through the PAYE system, then a PAYE agency is likely to be the right choice for you.

If you want something that sits in between these two options, an umbrella company will take care of it. You will be given the flexibility to determine which contracts you work on while still having the security of being employed with a salary being paid through the PAYE system. You will also receive the same statutory rights. 

As an umbrella company provides a blend of the two, many contractors choose it, but you have to consider the indirect costs that come with them.

Indirect Costs to Consider

Umbrella companies and PAYE agencies both come with indirect costs related to a fee charged for providing the benefits on offer. The fee will also be implemented to cover contractors being added to the payroll, the handling of tax and National insurance contributions, statutory benefits, and managing invoices and filing. When it comes to umbrella companies, this will also cover claiming back business expenses.

The fee will be taken before the processing of tax, and contractors often find that the price they pay reflects the service they receive. In contrast to this, the self-assessment route comes with no fee, but in most cases, contractors need an accountant to help deal with their tax returns. Therefore, the costs associated with an accountant can increase considerably. Furthermore, managing income on a quarterly or yearly basis can also prove to be a challenge as you will need to ensure you actively manage how much you have to pay to HMRC as a lump sum. This requires discipline and the ability to plan, as the money will need to be kept separate.

This is why contractors opt for the umbrella route, so if this is your choice, you will need to identify an umbrella company that is right for you.

Choosing the right Umbrella PAYE Company

Contractors working in various roles and sectors will find that an umbrella company is the better option. This option brings together the flexibility of being self-employed and the peace of mind that you will receive a salary, too, with tax being paid through the PAYE system while still having access to statutory benefits. 

However, as more contractors have chosen to take advantage of this option, more umbrella companies have opened up. Therefore, they all claim to be better than one another, so it’s vital that you compare them to ensure you find the one that is right for you.

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