Your complete guide to salary sacrifice, and how it can reduce your tax bill

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Back in September, the prime minister announced that the rates of both National Insurance and Dividend Tax will rise in April 2022.

According to the Institute for Fiscal Studies this will increase the UK’s tax take to the highest level in peacetime. So, it’s perhaps no surprise that many of our clients are looking at ways they can mitigate their potential liability to a range of taxes.

If you’re employed, one way you can consider reducing the amount of Income Tax and National Insurance contributions (NICs) you pay is by using “salary sacrifice”. This is where you voluntarily reduce your earnings in exchange for an equal amount paid through a tax-free benefit.

While this benefit can include a company car or childcare vouchers, it’s most commonly used where an employee exchanges part of their income for additional pension contributions.

Read on to find out how salary sacrifice works, and how it can result in a boost to your pension fund and a lower tax bill.

How salary sacrifice works

Under a salary sacrifice arrangement, you would give up part of your salary or bonus with your employer paying this amount directly into your pension. This is different from the normal “net pay” system where your contributions are deducted from your pay before your salary is taxed.

While your pension payments are free from Income Tax (or are eligible for pension tax relief if they are paid after Income Tax), they are usually subject to NICs.

  • NICs are charged at 12% of your salary on anything you earn between £9,568 and £50,270 (rising to 13.25% in 2022/23) and at 2% (rising to 3.25% in 2022/23) for everything earned above that.
  • Your employer also pays 13.8% of your salary (rising to 15.05% in 2022/23) between £8,840 and £50,270 in National Insurance payments.

However, if you pay pension contributions through salary sacrifice, they do not form part of your pay and are free from National Insurance charges.

This benefits you – you pay less NICs – and it benefits your employer as they pay less NICs also. Indeed, some employers will redirect the NIC savings they make into your pension as an additional perk.

An example of how salary sacrifice could benefit you

Insurer LV= has looked at how a person earning £50,000 could gain more than £1,000 a year by using salary sacrifice.

Imagine you earn £50,000 and you want to pay 10% (£5,000) of your salary into your workplace defined contribution (DC) pension.

If you paid £5,000 into your pension using the traditional “net pay” system, you would take home £33,662 and your yearly pension contribution would be £5,000. The total you would receive across your take-home pay and pension contributions is £38,662.

However, if you decided to take advantage of your employer’s salary sacrifice option (where your employer agrees to pass on its NIC savings), you could end up with more.

If you “sacrificed” £5,000 directly into your pension pot, you would save £600 a year in NICs. Your employer would add this to your take-home pay.

Your employer would also save £690 in NICs which they could redirect to your pension, boosting your fund by this amount.

Your take-home pay would increase by £600 to £34,262 and your annual pension contribution would rise by £690 to £5,690. Your total in this scenario is £39,952.

Some things to consider before you start

As you have read, salary sacrifice can boost your pension pot and reduce the amount of tax you pay. However, before you sign up, there are a couple of drawbacks you need to consider.

First, when you use salary sacrifice, you effectively lower your salary. This will have a knock-on effect when you come to apply for finance based on your salary (such as a mortgage). Your borrowing potential may therefore be lower.

In addition, in the event you are made redundant, your redundancy pay may be based on the lower income figure.

Using salary sacrifice also means your entitlement to other workplace benefits could be reduced. Your death in service life cover may be based on a multiple of your lower salary, or your maternity/paternity pay could be lower.

Earn over £100,000? Salary sacrifice could help you get your Personal Allowance back

As well as reducing your National Insurance bill and boosting your pension pot, salary sacrifice into your pension can also have Income Tax benefits if you earn above £100,000.

Your Personal Allowance – the amount you can earn before you start paying Income Tax – is reduced by £1 for every £2 of income above £100,000. So, the effective tax rate you pay on salary between £100,000 and £125,140 is an eye-watering 60%.

This is the triple impact of paying 40% tax on income over £100,000, losing the Personal Allowance, and paying 40% on that income too.

Salary sacrifice can help here also. The example below shows the difference a personal pension contribution of £25,140, and salary sacrifice of £25,140, can make if you have an income of £125,140.

The figures are based on UK Income Tax and National Insurance rates, excluding Scotland, in the 2021/22 tax year. The salary exchange figures assume that the employer has passed on the savings they’ve made in reduced NICs by making a higher pension contribution.

Source: Royal London

  • Making a standard pension contribution results in total income of £86,298.36 (net income plus net pension contribution).
  • Using salary sacrifice results in total income of £95,298.48 (net income plus employer pension contribution).

Get in touch

The decision to use salary sacrifice will be a personal choice. However, for many people, the tax benefits will outweigh the disadvantages – particularly if your employer agrees to pass on the NICs saving.

To find out more about how salary sacrifice could help you, or if you want to discuss your pension contributions, please get in touch. Email or call 01454 416653.

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