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Following the introduction of the MSC legislation, if you choose to receive your payments through a third party rather than managing your own limited company, your payments must be processed through PAYE.

PAYE stands for Pay As You Earn which means that, as a contractor, you will pay your tax and National Insurance contributions as you go along in exactly the same way as a permanent employee.

PAYE calculations are determined by HMRC, with both income tax and national insurance contributions being deducted as a percentage of your earnings.

National Insurance Contributions (NICs)

There are 2 types of National Insurance Contributions - employees' and employers'. The value of the employers' NI contribution is deducted from the gross rate offered in your agency contract before the umbrella company calculates your salary.

Both employees' and employers' NI for 2010/2011 are payable on earnings above £111 per week and are calculated at 11% and 12.8% respectively. Employees' NI is capped at £844.00 per week; for earnings over this amount the percentage deducted reduces to 1%. Employer contributions are at 12.8% and are uncapped.

Income tax deductions

Income tax is also calculated according to percentages over and above allowances set by HMRC. Everyone has a tax code which determines their tax free pay e.g. the standard tax code for 2010/11 is 647L, which means that you can earn up to £6475 per annum before you will be liable for income tax.

Every pound you earn over your tax free allowance will be taxed at 20% up to £37,400; every pound you earn over £37,400 will be taxed at 40%.
For earnings over £100,000 per annum the tax free allowance will reduce by £1 for every £2 over £100,000 that is earned. Earnings over £150,000 are taxed at 50%.

PAYE umbrella company expenses

The other consideration with an umbrella company is that you will be able to claim certain costs as expenses. Those that are payable by your agency or client will be reimbursed to you in full and are referred to as 'chargeable' expenses.

Expenses that are not refundable through your agency or client are referred to as 'con-chargeable' and are processed by the umbrella company as a tax benefit. This means that your taxable income is reduced by the value of the expenses e.g. salary of £400 per week with non-chargeable expenses of £100 will give taxable earnings of £300 thereby reducing your income tax liability.

You should remember that HMRC decide what can be claimed as an expense and not your umbrella company. The only difference in take-home pay between all the umbrella companies in the market place should be caused by differences in the fees that they charge and, obviously service levels.

Beware 'higher net pay' umbrella company claims

Finally, and this is vitally important, ALL Umbrella Companies operate under the same rules and regulations which means that there are no magical formulas, no elaborate schemes and no creative accounting that allows one company to give you a higher net pay than another.

This article was kindly provided by Russell Duke from Contractor Umbrella.