How the Pay As You Earn system works

Whether you’re a sole trader, limited company director or umbrella employee, it’s essential to understand how you’ll be taxed.

There are various methods HMRC uses to collect taxes. But, for this article we’ll hone in on the differences between the self assessment tax system and Pay As You Earn.

How is PAYE calculated?

Paye As You Earn sees your income tax deducted from your wages or salary at source, by your employer, on behalf of HMRC. You don’t have to worry about it or file any paperwork (unless you earn over £100,000 in a tax year, in which case you’ll need to complete a self assessment tax return too).

Your tax code tells your employer how much tax to deduct, and how much tax you pay depends on what you earn. Most people have a personal tax-free allowance of £12,570 (for the 2022/23 tax year). Earnings between £12,571 and £52,270 are subject to the basic rate of income tax (20%), and earnings between £50,271 to £150,000 are taxed at 40%.

Alongside any income taxed via Pay As You Earn, you can earn an additional £1000 tax-free through any self-employed work. This is referred to as your ‘trading allowance’.

PAYE and Self Assessment

So, employees – including umbrella company workers, who we cover in more detail below – are taxed via Pay As You Earn.

However, the self assessment is used by self-employed workers – whether sole traders or individuals operating via their own limited company – and some high-earning payrolled workers, to report their taxable earnings to HMRC and to pay the tax they owe.

While the self assessment can be daunting if you’ve not done it before, keeping on top of your business finances and staying organised will help when it’s time to complete and file your personal tax return.

If you’re not confident completing the self assessment, a trusted accountant like Caroola can help.

PAYE as an employer

As permanent employees, umbrella workers are taxed via Pay As You Earn.

Umbrella companies will deduct income tax and National Insurance Contributions from an umbrella worker’s overall pay, plus pension contributions and other deductions (like student loan repayments, for example).

A contract of employment exists between umbrella companies and their workers, and so umbrellas must provide statutory benefits, including the minimum annual leave entitlement and statutory sick pay. As taxable income, holiday pay is also subject to the Pay As You Earn process.

As employers, umbrella companies also have to pay National Insurance Contributions for each qualifying worker, either Class 1A or 1B.

The same applies to those owning limited companies who hire employees.

A quick recap

So, Pay As You Earn and self assessment are the two systems HMRC uses to recover taxes.

PAYE is automatically deducted from the gross pay of payrolled employees (including umbrella workers). In contrast, sole traders and the self-employed will use the self assessment.