Pension contributions via salary 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 (NI) savings for employers.
• Therefore, the employer could increase the contribution by some of their NI savings at no extra cost.
• Potentially most attractive to employees with salaries exceeding £100,000 (can potentially use to keep personal allowance).
• 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.
• New sacrifices after 8 July 2015 not effective for high earners to avoid the tapered annual allowance.
• Cannot sacrifice salary to an amount below the minimum wage.

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

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 10% 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 13.8%.

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

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

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

Any new salary sacrifice arrangements entered from 9th July 2015 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 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%. This saving can be passed on in the form of an increased pension contribution as 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, there are occasions where salary sacrifice can potentially benefit the employee even further.

The personal allowance for people with earnings more than £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 £125,140 will have no personal allowance. Therefore, any salary sacrifice for people with salaries over this level may be useful to reclaim their personal allowance.

Current NI rates and thresholds 

The Primary Threshold (PT) for the level to start paying NI (and the Lower Profit Limit for the self-employed).

The rates and thresholds of NIC for employees and employers

It is intended that the Primary Threshold and Lower Profit Limit will continue to be in line with the level of the income tax Personal Allowance going forward.

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 influence 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 influence 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 (e.g., 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 the pension contribution as an off-settable 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.

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 £5,422.40 gross. The client would have increased their take home pay by £1,056.

Further information

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

• www.hmrc.gov.uk/manuals/eimanual/EIM42750.htm
• www.hmrc.gov.uk/specialist/salary_sacrifice.pdf