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Pension salary/bonus sacrifice

Salary sacrifice allows an employee to give up an amount of their salary and replace it with an employer’s pension contribution creating a larger pension contribution than they would have paid themselves for the same or lower net cost.

At a glance

  • Normally, tax saving at highest marginal rate for employees.
  • National Insurance savings for employees.
  • Corporation tax relief for employers.
  • National Insurance savings for employers.
  • Potentially most attractive to employees with salaries in excess of £100,000.
  • Need to consider the impact of reduced salary for state benefits, loans, mortgage applications, etc.
  • Possible reduction in the costs of auto enrolling new members to workplace pension schemes.

How it works

The concept behind salary sacrifice is twofold:

  1. to benefit the employee by providing a greater pension contribution, and
  2. to benefit both the employee and employer through potential National Insurance (NI) savings, all at no extra cost.

For the employee

Employees normally receive tax relief on their pension contributions through one of the two following methods.

Net pay arrangement

If the contribution is paid via the net pay arrangement (through an occupational pension scheme where the employer collects the pension contribution), the tax relief is granted immediately. This is because the pension contribution is collected directly from the gross salary before income tax is deducted. Therefore the income tax transaction that would have been paid and then reclaimed happens immediately including any higher-rate tax relief.

Relief at source

If the contribution is paid via the relief at source method, the tax relief will not be given immediately, as is the case in the net pay arrangement. Instead, the client will pay the contribution net of basic-rate tax to the pension provider. The pension provider will claim back the basic-rate tax from HM Revenue & Customs (HMRC) and apply this to the pension investment. The client will then claim back any higher-rate tax relief due from HMRC. This will extend the client’s basic-rate tax band by the gross amount of the pension contribution and thus removes the liability for the client to pay higher-rate tax on that element.

It’s worth noting for both the above scenarios that NI contributions (NIC) will still be due on the whole salary and this is not reclaimable against any pension contributions.

By using salary sacrifice the employee gives up a level of salary and will therefore pay less tax and NI. If salary sacrifice does not occur the employee obtains income tax relief on the pension contribution, but still incurs NI deductions on the amount of the pension contribution. Depending on the employee’s level of salary, this could account for either 12% or 2% of the additional salary, or a combination of the two. By sacrificing salary the employee will effectively see this saving as part of their overall net income.

For the employer

When an employer pays an employee a salary, the cost of this is offset against their business expenses and their corporation tax bill (the tax which companies pay on their net profits). However, all salary payments are subject to employer NI payments. This NI payment is usually 13.8%. 

If an employer also pays a pension contribution for the employee, the amount is also offset against their expenses and corporation tax bill. However, when making a pension contribution, there is no employer’s NI to pay.

Consequently, if salary sacrifice was to take place, the employer will be making an NI saving equivalent to the NI they would have paid on the sacrificed income. This effectively reduces the employer’s expenses, and makes salary sacrifice attractive.

If the employer wishes, they can pass this NI saving on to the employee either partially or completely as an increased pension contribution. If the whole amount was passed on, this would be cost neutral for the employer in comparison to the total expenses they were paying before the salary sacrifice.

As you can see from the notes above, salary sacrifice can be an effective and cost-efficient way for the employer to help the employee increase their pension contribution, at no extra cost to themselves.

If a salary sacrifice exercise is being introduced, the employer must ensure they follow employment law and may have to make amendments to employment contracts.

HMRC

HMRC requires two conditions to be met before they will consider a salary sacrifice to be effective:

Condition 1: the potential future salary must be given up before it is treated as received for tax and NI purposes.

Condition 2: the contractual arrangement between the employer and employee must be that the employee is entitled to a lower cash salary and a benefit.

Combined together, these conditions need to show the employee’s contractual right to cash payment for this part of the salary has been removed.

In addition to these requirements from 9th July 2015 it has been stated that any new salary sacrifice arrangements will not be effective for the calculation of threshold income for tapered annual allowance purposes. Please read our Tapered Annual Allowance article for further details.

Information to be given to HMRC

To decide if a salary sacrifice is effective or not, HMRC will review the total construction of the revised contractual arrangements. If asked, the employer will need to prove to HMRC that the employee’s entitlement to cash pay has been reduced, that the non-cash benefit (pension contribution) has been provided, and that the sacrifice is not simply the employer meeting the employee’s own financial commitments.

Although it’s not necessary, many financial advisers recommend that HMRC is advised when a salary sacrifice arrangement is put into place.

National Insurance

The main benefit of salary sacrifice is the potential for the employee’s pension contribution to be increased at no additional cost to the employer due to the NI savings made when they change from paying the salary to the employee to paying a pension contribution, as these do not attract any NI charges.

Currently, the standard employer charge for NI is 13.8% (2016/17). This saving can be passed on in the form of an increased pension contribution; many employers give up all or part of this ‘saving’ to enhance their pension contribution.

Potential further benefits

Although many employees can benefit from greater pension contributions and tax savings, and employers can provide benefits for their employees at no additional cost and save NI payments, there are occasions where salary sacrifice can potentially benefit the employee even further:

  • If an employee has earnings above the NI lower earnings limit (LEL), currently £5,772, but below the primary threshold (PT), currently £8,060, any S2P benefit will be based on a notional salary equalling the PT in all cases. For employees with salaries between these two levels it may be beneficial to use salary sacrifice to take salaries down to the LEL. This will have no effect on their S2P rights but they will make savings in NI contributions from their salary. Plus they can use this fund, with possibly employer’s NI savings, to increase pension contributions.
  • From April 2010, the personal allowance for people with earnings in excess of £100,000 is reduced by £1 for every £2 of income over this amount. This means that, assuming full personal allowance, any person earning over £122,000 will have no personal allowance. This increases the employee’s effective tax liability on any excess income over £100,000 from 40% to potentially as much as 60% when also considering the loss of the personal allowance. To regain the full personal allowance, the client would look to sacrifice all income above £100,000. They would therefore reduce this tax liability and increase pension contributions with, hopefully, the addition of some of the employer’s NI savings from this sacrifice. Obviously the 60% tax figure is only applicable for earnings between £100,000 and £122,000 and, if the employee has a larger salary, the tax figure will be less than 60%.  This is discussed further in the article Removal of Personal Allowance.
  • Employees pay NI at the full rate up to the upper earnings limit (UEL), currently £41,865 (2014/15). However, S2P only accrues to the upper accrual point (UAP), currently £40,040. This means that employees earning between these two amounts are paying full NI for no benefit from S2P. In these circumstances it may be beneficial to sacrifice their salary down to the UAP in return for an employer pension contribution of the same amount.

NI rates and thresholds for 2016/17

  • Employees pay NI at the full rate up to the upper earnings limit (UEL), currently £43,004 (2016/17). 

The rates and thresholds of NIC for employees and employers

Employee (primary)

Employer (secondary)

Earnings
£ per week

NIC rate
percent

Earnings
£ per week

NIC rate
percentage

Below £112 (LEL)

0%

Below £112 (LEL)

0%

£112 to £155

0%

£112 to £156

0%

£155.01 to £827 (UEL)

12%

Above £156

13.8%

Above £827

2%

 

 

Areas to consider

Although salary sacrifice can be beneficial to the client and employer at no extra cost, there are other factors that need to be considered by both parties.

Minimum wage

Please note that salary sacrifice cannot reduce a salary to below the minimum wage.

Personal circumstances

Definitions of salary can be used for many things that will affect the finances and borrowings available to an employee, and these will need to be considered.

Personal loans and mortgages are based on either salary or multiples of salary, and a lower salary after the sacrifice may have an effect on the borrowing limits the lenders will impose.

Permanent health insurance is generally based on a percentage of earnings before the date on which incapacity commenced. The income that is received from this sort of benefit is paid free from taxation and NI. If the salary is reduced due to sacrifice, the amount that the employee can claim may reduce.

It can be very confusing for clients to determine what their salary is and what their benefits/borrowings may be based upon if salary sacrifice has been implemented. For this reason some employers will show the salary on their payslip both before and after the sacrifice has taken place.

Contractual agreements

Any amendments made to the level of salary contribution (and possibly pension contributions) will need to be reflected in the terms of the employee’s contract. Please note that this may have an effect on other benefits provided by the employer, such as life cover (possibly based on four times salary) and even bonus payments if based on percentage of salary. However, some companies will offer these additional benefits on a notional earnings basis (eg calculated on the pre-salary sacrifice earnings).

Corporation tax relief

Generally, an employer’s pension contribution can be offset against corporation tax liabilities in the same way that an employee’s salary is. However, if HMRC determines that the overall remuneration package the employee is receiving is excessive for the duties they perform HMRC have the right to refuse to accept some or all of the pension contribution as an offsettable business expense. It is also worth noting that once a pension contribution has been paid by the employer it cannot be refunded unless it can be proven to be an ineligible contribution.

Examples

The examples below show how salary sacrifice could affect the level of pension contributions for the member at no extra cost to the employer. Both examples are for personal pension contributions, but the same principle is used for occupational pension schemes. The assumption has been made in both cases that the clients have full personal allowances of £11,000.

Example 1*: salary £30,000, personal pension contribution £400 per month (£4,800 per year (£3,840 net)). Assume employer has given up full NI saving and member gives up equivalent gross pension contribution.

 

Current position

New position

Difference

Gross Salary

£30,000

£25,200

£4,800

Employee NI liability

£2,632.80

£2,056.80

£576

Employer NI liability

£3,020.54

£2,358.14

£662.40

Employee tax

£3,800

£2,840

 

Net personal contribution

Basic rate relief on pension contribution    £960  

£3,840

 

 

Net income after pension contribution

£19,727.20

£20,303.32

£576

It should be noted that if the member is a higher-rate taxpayer they will receive the higher-rate relief from HMRC through self-assessment.

Based on the above scenario, if the client sacrifices salary equal to the gross pension contribution of £4,800 and the employer passes on the full NI saving, the pension contribution would be £5,462.40 gross.

Example 2*: salary £50,000, personal pension contribution £400 per month (£4,800 per year (£3,840 net)). Assume employer has given up full NI saving and member gives up equivalent gross pension contribution.

 

Current position

New position

Difference

Gross Salary

£50,000

£45,200

£4,800

Employee NI liability

£4,333.20

£4,237.20

£96

Employer NI liability

£5,780.54

£5,118.14

£662.40

Employee tax (taking into account tax relief on pension contribution)

£9,200

£7,280

 

Net personal contribution

Basic rate relief on pension contribution    £960  

£3,840

 

 

Net income after pension contribution

£32,626.80

£33,682.80

+ £1056

It should be noted that if the member is a higher-rate taxpayer they will receive the higher-rate relief from HMRC through self–assessment and this is not included within the final net income calculation.

Based on the above scenario, if the client sacrifices salary equal to the gross pension contribution of £4,800 and the employer gives up the full NI savings the pension contribution would be £5,462.40 gross.

Further information

Further information can be found on this subject on the following HMRC website pages:

*These examples are based on 2016/17 tax rates.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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