Pay as you earn (PAYE)

Definition

Pay as you earn (PAYE) is a system of income tax withholding used by employers to deduct tax from employees’ wages or salaries in real-time, as they are earned. 

What is pay as you earn?

Pay as you earn is a common method of collecting income tax in many countries and it ensures that individuals pay their taxes throughout the year, rather than in a lump sum at the end of the tax year, making it easier to manage their tax obligations.

Under the PAYE system, employers are responsible for deducting income tax from employees’ paychecks based on their earnings and tax code. These deductions are then remitted to the tax authority on behalf of the employee.

Employers are required to report PAYE deductions to the tax authority in real-time, usually on or before each payday. This ensures that tax payments are accurately recorded and reconciled with employees’ earnings, providing transparency and accountability in the tax collection process.

Employers have several responsibilities under the PAYE system, including registering with the tax authority as an employer, deducting and paying taxes from employees’ pay, providing employees with pay statements detailing their earnings and deductions, and submitting payroll reports to the tax authority.

PAYE provides employees with the convenience of having their taxes deducted automatically from their paychecks, eliminating the need to make separate tax payments or calculate tax liabilities. It also facilitates budgeting and financial planning by spreading tax payments evenly throughout the year.

Example of pay as you earn

John works as a software engineer at XYZ Tech Company. His monthly salary is £5,000. Under the PAYE system, XYZ Tech Company deducts income tax from John’s paycheck based on his earnings and tax code.

Let’s assume John’s tax code indicates that he is entitled to a personal allowance of £1,000 per month before any tax is deducted. Additionally, the income tax rate applicable to his earnings above the personal allowance is 20%.

Using the PAYE system, XYZ Tech Company calculates John’s tax deduction as follows:

• John’s gross monthly salary: £5,000
• Personal allowance: £1,000

Taxable income: Gross monthly salary – Personal allowance = £5,000 – £1,000 = £4,000

Income tax deduction: Taxable income × Tax rate = £4,000 x 20% = £800

Therefore, XYZ Tech Company will deduct £800 from John’s monthly salary as income tax under the PAYE system.