What is PAYE – the basics of payroll explained

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Whether you’re an employer, an employee, or anywhere in between, PAYE is a term you’ll have heard about. But, what does this actually mean, and how does it impact the way you pay employees or receive your salary?

Read on to find out the basics of PAYE and what it means for you.


What is PAYE in simple terms?

PAYE stands for Pay As You Earn, a way for employees to be paid. This means your income tax and National Insurance (NI), and other deductions like student loan repayments and pension contributions, are taken from your salary and sent to HMRC each time you are paid by your employer. Your wages can also include sick pay and parental leave.

Employers use payroll software or an accountant to conduct PAYE. As an employee, you’ll receive your net pay (after taxes) and a payslip with a summary of deductions. You’ll also get a P60 at the end of each tax year to set out your total wages and deductions for the previous tax year.

PAYE is different from self-assessment tax returns, where taxes are paid once or twice a year. Paying contributions as you earn is the easiest way to pay taxes, making PAYE the most common way for employees to be paid.


How much tax is paid under PAYE?

HMRC uses tax codes to determine how much tax should be deducted from your wages or pension.

A PAYE code is compromised of a number and a letter:

  • The number outlines the amount of tax-free income you can receive in a year, also known as personal allowance. To create the code, this is usually divided by 10.
  • The letter relates to the type of allowances you will receive. This can relate to your country of residence in the UK or your number of jobs.

The most common tax code for those with one job or pension is 1250L. This means the employee will receive the standard tax-free personal allowance of £12,500.

In the case of HMRC not having enough information to issue a full tax code, for example, if you start a new job, you will receive an emergency tax code until this is received.

Each year, employees and employers will receive a notice of coding letter from HMRC. This outlines the appropriate tax code for PAYE employees to ensure they pay the correct taxes and NI. If your circumstances change during the tax year, you’ll need to notify HMRC, otherwise you could end up with an outstanding tax amount.

It’s worth checking your tax code, as you may be eligible for a tax refund if you have been paying more than you should. Employees are responsible for addressing a suspected incorrect tax code.


Calculator to work out tax


How do employers pay employees using PAYE?

Employers will pay an employee’s salary including any bonuses, or sick pay or parental leave. They will deduct any relevant taxes or NI based on the employee’s tax code. There may also be other deductions, including student loan repayments or pension contributions.

Some employers will operate PAYE themselves (here’s how to choose payroll software), while others may hire an accountant. Regardless, the way employees receive their salary will be the same, although the portal to access payslips and documentation may vary.

Your employer, or their accountant, will report employees’ payments and deductions to HMRC on or before each payday, plus an annual report. Employers will also pay a NI contribution on earnings above £169 a week. They will also be able to claim reductions on what they owe, such as sick pay. Any changes to circumstances, including new employees or an employee reaching pension age, should also be reported.


How does PAYE work for contractors under agency or umbrella PAYE?

A contractor has several payment options, including agency PAYE, umbrella PAYE, or a limited company. Both agency and umbrella PAYE refer to being added to the payroll of the respective party.

Under agency PAYE, the money for work completed is collected from the client by the agency and then paid to the contractor. If the contractor uses an umbrella company, the agency will instead pass the funds onto them and they will run payroll and make any necessary deductions.

In terms of how contractors are paid and receive their wages, this will be no different to a full-time employee. A tax code will be used, and deductions made before their salary is received. However, agency workers sometimes have fewer employee benefits due to not being employed by the agency.

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