Higher rate earners – are you missing a trick?
As purse strings are tightened, how can employers and employees maximise tax efficiency whilst topping up their pensions?
It has become common practice for employees to exchange part of their salary and/or bonus in return for their employer paying the exchanged amount as an employer pension contribution.
This is commonly known as ‘salary sacrifice’. This is where the employee exchanges part of their salary for increased pension contributions. This can not not only reduce tax (handy for those wanting to keep away from £50k where they may lose child benefit), but it also reduces NI for both the employee and the employer. Taxpayers could also benefit because a reduction in their salary could mean reducing, or eliminating, the high income child benefit charge on income above £50,000. You might also use salary exchange planning – for a taxpayer with income between £100,000 and £125,140 – to reclaim the personal allowance in addition to the income tax and NI savings. In addition, for higher rate and additional rate taxpayers there is a cash flow advantage for making pension contributions through salary exchange. The benefit of higher rate tax relief is felt immediately rather than having to claim on a self-assessment tax form.
Salary or bonus exchange requires an employee to agree to change their terms and conditions of employment relating to pay.
Under their revised contract, the employee gives up some of their salary, or contractual bonus, in return for a non-cash benefit from the employer, for example, an employer pension contribution.
Exchanging salary for pension contributions will reduce the employee’s earnings. That usually means the employee will pay less income tax and NI than before.
Increasing pension or increasing take home pay?
Once the employer has set up the salary exchange and thereby established an employee saving from reduced NI, there are two options to consider:
- the same pension contribution can be made at a lower cost to the employee, which will increase their take-home pay, or
- a larger pension contribution can be made without affecting the employee’s net take-home pay.
Benefits for the employer
Employers do not pay NI on pension contributions for employees. So, exchanging an employee’s earnings usually means that the employer will pay less NI than before.
Employers usually pay NI on all earnings above the threshold, so the employer will normally see a saving of 13.8 per cent on the exchanged amount
Let’s look at a specific example:
Stoke Adviser ltd, has two employees, Jill and John, both aged 40 and earning £40,000 gross a year. They have a pension scheme that deducts a 5 per cent employer and 5 per cent (4 per cent net) employee contribution of gross salary. They both have the standard personal allowance.
Jill wants to increase her pension contributions while John wants to increase his take home pay. Assuming the employer agrees to pay 100 per cent of their NI savings, the position would be as follows.*
|Net pay summary||Before salary exchange||John, after salary exchange||Jill, after salary exchange|
|Annual salary (gross)||£40,000||£38,000||£37,603|
Total income tax
|Total national insurance||£3,634||£3,369||£3,317|
|Employee pension (net)||£1,600||£0||£0|
|Total net take-home pay||£29,280||£29,585||£29,280|
|Increase in take-home pay||£265||£0|
|Increase in pension||£0||£397|
|NI saving to pension||£301||£361|
|Total pension increase||£301||£758|
*Scottish Widows Salary Exchange Calculator 14/09/2022.