How Pay as You Earn (PAYE) works

Paying taxes is one of the few certainties in life. For all self-employed workers, ensuring you pay the right amount of tax is one of your most important responsibilities.

Independent workers generally use self-assessment to calculate and pay the tax they owe personally, but there’s another method: Pay As You Earn (PAYE). This is how payrolled workers – including employee employees – have their earnings and taxable income reported to HMRC. But how does Pay As You Earn work in practice? Read on to find out.

How is PAYE calculated?

Pay As You Earn is worked out in two ways. Firstly, your annual income determines which tax band you fall into. There are three: basic rate (20%), higher rate (40%) and additional rate (45%). Your tax code also tells your employer how much tax to deduct.

Tax Band Threshold Upper Limit
Basic Rate £12,571 £50,270
Higher Rate £50,271 £150,000 
Additional Rate £150,001  

Most of the time, your tax code should reflect your tax-free personal allowance (fixed at £12,570 until 2028). Any deductions to your income will be made after taking that figure into account.

So, if you earn £30,000 in the 2023/24 tax year, you’ll pay income tax at a rate of 20%. The first £12,570 that you earn is all yours, though – so your taxable income is £17,430. That makes your total income tax liability for that year £3486.

If you’re struggling with the sums – or you’d just like to double-check your workings out – you can use HMRC’s Paye As You Earn calculator 

PAYE and National Insurance

As well as your Income Tax, your National Insurance contributions are deducted through PAYE, too. This is calculated in a similar way. Each employee will have a National Insurance category letter, and each of these letters has a different rate attached to it, depending on the employee’s monthly earnings.

Again, HMRC has a calculator to help employers work out what the NI deductions should be for each employee.

PAYE and Self Assessment

Pay As You Earn and self assessment are methods for calculating your earnings and taxable income. Which one you use depends on how you work and how you pay yourself. If you’re a contractor operating outside IR35 or a sole trader, you’ll likely complete the self assessment to report your personal earnings and taxable income to HMRC.

For payrolled workers – whether umbrella employees or any other individual taxed under PAYE – the reporting is done by the employer who makes the relevant deductions from the employee’s gross pay. 

PAYE as an employer

Not all employers need to register for PAYE; if your employees earn less than £123 a week, for example, you won’t have to register. But employees earning above that mean you will have to be PAYE registered. Employers can use payroll software to calculate the relevant tax deductions for their employees, which they’ll pay to HMRC monthly. You can usually pay quarterly, however, if the taxes total less than £1500 per month.

So, Pay As You Earn and Self Assessment are the two ways that HMRC collects taxes owed, from payrolled staff and the self employed, respectively. When operating on the payroll – for an end client or via an umbrella company – or within IR35, your income will be taxed via Pay As Your Earn.

With over 20 years of experience, Parasol is a trusted provider of compliant umbrella solutions.

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