Salary sacrifice can be one of the most tax-efficient ways to contribute to a pension, particularly for higher earners, employees receiving bonuses and those earning around or above £100,000.
But the benefit isn’t simply about putting more money into your pension. Used correctly, salary sacrifice can reduce Income Tax and National Insurance, help protect your Personal Allowance and, in some circumstances, help preserve valuable Child Benefit or childcare entitlement.
The key is to plan before the income is paid.
What is salary sacrifice?
Salary sacrifice is an agreement with your employer to give up part of your contractual salary in exchange for a non-cash benefit, such as an employer pension contribution.
For example, suppose you earn £80,000 and want to put £10,000 into your pension.
Instead of receiving the full £80,000 and making a personal pension contribution, you could agree to reduce your salary to £70,000, with your employer paying £10,000 directly into your pension.
Because you have given up the salary before receiving it, the sacrificed amount is generally not subject to Income Tax or employee National Insurance.
Why is salary sacrifice tax efficient?
Using salary sacrifice for pension contributions can provide several benefits:
- lower taxable employment income;
- lower employee National Insurance;
- increased pension contributions; and
- lower employer National Insurance costs.
The employer’s National Insurance saving is particularly interesting.
Some employers retain the saving, while others agree to pay some or all of it into the employee’s pension. Where this happens, the overall benefit can be even greater.
Earning over £100,000? Salary sacrifice becomes particularly interesting
One of the most important areas for salary sacrifice planning is the £100,000 income threshold.
Once adjusted net income exceeds £100,000, your Personal Allowance is reduced by £1 for every £2 of additional income.
This creates an effective 60% Income Tax rate on part of the income between £100,000 and £125,140.
For example, if your normal salary is £95,000 but you are expecting a £15,000 bonus, simply accepting the bonus could push your income into this highly taxed band.
Depending on your circumstances, sacrificing some of the bonus into your pension could produce a significantly better overall outcome.
This is why tax planning should ideally happen before your bonus becomes payable.
Could it help protect your Child Benefit?
Pension planning can also be valuable if you or your partner receive Child Benefit.
The High Income Child Benefit Charge is linked to adjusted net income.
Appropriate pension planning that reduces adjusted net income can therefore reduce the Child Benefit tax charge and, depending on your circumstances, potentially eliminate it.
This means the effective financial benefit of a pension contribution can sometimes be considerably greater than the pension tax saving alone.
What about the £100,000 childcare threshold?
The £100,000 income level is also important for parents using certain government childcare schemes.
Tax-Free Childcare and the working-parent childcare entitlement are subject to an adjusted net income limit of £100,000 per parent.
This can create a significant cliff edge.
If your income is expected to exceed £100,000, appropriate pension planning could therefore potentially help you retain valuable childcare support as well as protect some or all of your Personal Allowance.
This is an area where planning before the end of the tax year can make a substantial difference.
Salary sacrifice can benefit employers too
There is also a benefit for the employer.
Reducing an employee’s contractual cash salary can reduce the employer’s National Insurance liability.
Employers can retain that saving or choose to contribute some or all of it to the employee’s pension.
For businesses, salary sacrifice can therefore form part of a more attractive and tax-efficient employee benefits package.
For directors of owner-managed companies, however, salary sacrifice isn’t necessarily the best option. It may be more appropriate for the company to make an employer pension contribution directly.
The alternatives should be compared before taking action.
When should you consider salary sacrifice?
It is particularly worth reviewing if:
- your income is approaching or exceeding £100,000;
- you are expecting a significant bonus;
- you are a higher or additional-rate taxpayer;
- you already make substantial personal pension contributions;
- you are losing some or all of your Personal Allowance;
- your income is affecting Child Benefit or childcare entitlement; or
- your employer is prepared to share its National Insurance saving.
What are the potential drawbacks?
Salary sacrifice isn’t suitable in every situation.
Reducing contractual salary can potentially affect mortgage affordability, statutory payments and benefits linked to salary.
Pension allowances must also be considered. Significant pension contributions can interact with the annual allowance and, for some higher earners, the tapered annual allowance.
Most importantly, salary sacrifice needs to be put in place correctly and at the right time.
You generally cannot receive or become entitled to a bonus and then retrospectively decide to treat it as salary sacrifice.
Don’t wait until after you’ve been paid
This is perhaps the most important point.
Tax planning is most valuable when it happens before the transaction or payment takes place.
If you’re expecting a bonus, pay rise or other income that could take you through an important tax threshold, the question shouldn’t simply be:
“How much tax will I have to pay?”
A better question is:
“Is there anything I can do before I’m paid to improve my overall tax position?”
At AJN Accountants, we help clients look ahead at their expected income, bonuses, pension contributions and key tax thresholds so that planning opportunities can be considered before it is too late.
Expecting a bonus or approaching £100,000 of income?
Speak to AJN before the income is paid. We can review the numbers and help identify whether salary sacrifice, pension contributions or other tax-planning opportunities should be considered.
AJN Accountants provides tax advice rather than regulated investment advice. Pension and investment suitability should be discussed with an appropriately authorised financial adviser.
