How Does Salary Sacrifice Work?

Salary sacrifice is an arrangement between an employer and an employee where the employee agrees to give up part of their pre-tax salary in exchange for non-cash benefits. These benefits can include increased pension contributions, a company car, childcare vouchers, or other perks that may be more tax-efficient than receiving the full salary in cash. The main advantage of salary sacrifice is that it can reduce the employee's taxable income, which could result in savings on both Income Tax and National Insurance Contributions (NICs).

What is it?

Salary sacrifice, sometimes known as salary exchange, is an agreement to reduce an employee’s salary in return for a benefit of equivalent value. The amount sacrificed is taken out of the gross salary (before tax and NICs are applied), which can lead to significant savings for both employees and employers.

Once the salary sacrifice is agreed upon, it becomes a formal part of the employee's contract, and the reduced salary will be used to calculate taxes and other statutory benefits.

For example, an employee with a salary of £35,000 may agree to sacrifice £2,000 for additional pension contributions. The employee's gross salary for tax purposes will now be £33,000, potentially reducing their tax and National Insurance liabilities.

How Does it Work?

Salary sacrifice works by allowing an employee to give up part of their salary in exchange for a non-cash benefit. The amount sacrificed is deducted from the gross salary, and this lower salary is then taxed and subject to National Insurance. This means the employee pays less tax and National Insurance, and the employer may also save on their NICs.

Here’s a step-by-step guide to how salary sacrifice works:

1. Agreement: The employee and employer agree on the amount to be sacrificed and the benefit to be received in return. This is a voluntary agreement.

2. Contract Amendment: The employee’s contract is updated to reflect the new, reduced salary.

3. Salary Reduction: The employee's salary is reduced by the agreed amount. For example, if the employee sacrifices £100 per month for a pension, their taxable income will be reduced by £1,200 per year.

4. Benefit Delivery: The employer provides the agreed benefit, such as pension contributions, childcare vouchers, or a company car.

5. Tax and NIC Savings: The employee and employer pay less tax and National Insurance due to the reduced salary.

What Are the Benefits?

Salary sacrifice offers various advantages, primarily centred around tax and National Insurance savings. Here are the main benefits:

1. Income Tax Savings

The salary sacrifice amount is taken out of the gross salary, reducing the employee’s taxable income. This means the employee will pay less Income Tax. For example, a basic-rate taxpayer who sacrifices £1,000 for pension contributions will save £200 in Income Tax.

2. National Insurance Savings

Since the salary is reduced before National Insurance Contributions are applied, both the employee and employer save on NICs. For example, if an employee sacrifices £2,000 per year, they could save 12% (basic-rate NIC) on that amount, equating to £240.

3. Enhanced Employer Contributions

In many cases, employers may pass on their National Insurance savings to the employee by increasing their pension contributions. This makes salary sacrifice particularly attractive for those looking to boost their retirement savings.

4. Flexible Benefits

Salary sacrifice allows employees to tailor their compensation packages to meet their individual needs. Common benefits available through salary sacrifice include:

• Pension contributions

• Cycle-to-Work schemes

• Childcare vouchers (for those who joined the scheme before it closed to new entrants)

• Company cars

• Healthcare plans

What Are the Drawbacks?

Despite the potential savings, there are a few drawbacks that employees should consider before entering a salary sacrifice arrangement:

1. Reduced Salary

While sacrificing salary offers tax savings, it also means a lower gross salary. This could affect certain salary-based benefits, including:

• Statutory Maternity Pay (SMP)

• Statutory Sick Pay (SSP)

• Redundancy payments

• Mortgage applications, as lenders consider your gross salary

2. Impact on State Benefits

A lower salary could also reduce your entitlement to state benefits that are linked to your earnings, such as the State Pension, as National Insurance Contributions are calculated on your post-sacrifice salary.

3. National Minimum Wage

Salary sacrifice cannot reduce an employee’s salary below the National Minimum Wage (NMW). Employers must ensure that after the sacrifice, the employee’s remaining salary does not fall below the legal threshold for the NMW.

Common Salary Sacrifice Schemes

There are various salary sacrifice schemes available, depending on the employer. The most popular schemes include:

1. Pension Contributions

One of the most common uses of salary sacrifice is for pension contributions. Employees can sacrifice part of their salary to receive increased pension contributions from their employer. This is an effective way to boost pension savings while reducing tax and NIC liabilities.

2. Cycle-to-Work Scheme

This scheme allows employees to hire a bicycle and related equipment from their employer in a tax-efficient manner. The employee sacrifices part of their salary to repay the cost of the bicycle over a set period, and the salary reduction reduces both tax and NICs.

3. Childcare Vouchers

While the childcare voucher scheme closed to new entrants in October 2018, those already in the scheme can continue to benefit from it. Employees can sacrifice part of their salary to receive vouchers that can be used to pay for childcare, offering savings on tax and NICs.

4. Company Cars

Many employers offer salary sacrifice schemes for company cars, particularly for low-emission vehicles. By sacrificing part of their salary, employees can use a car for personal and business purposes while reducing tax and NICs.

Salary Sacrifice and Pension Contributions: A Tax-Efficient Strategy

Salary sacrifice for pension contributions is particularly popular in the UK as it provides a tax-efficient way to save for retirement. In a typical pension contribution scenario, the employee contributes from their post-tax income. However, under a salary sacrifice arrangement, contributions are taken directly from the employee’s pre-tax salary, reducing their taxable income.

This can lead to significant tax savings. For example, a basic-rate taxpayer sacrificing £2,000 per year towards their pension could save £400 in tax (20%) and £240 in National Insurance (12%). Employers may also increase their pension contributions by passing on their own NIC savings.

How to Set Up a Salary Sacrifice Arrangement

To enter into a salary sacrifice arrangement, the following steps are generally involved:

1. Discuss with Your Employer: Speak to your employer to determine if salary sacrifice schemes are available and suitable for your situation. Many employers already have established schemes, particularly for pensions and cycle-to-work schemes.

2. Agree on the Benefit: Decide which benefit you want to receive in exchange for sacrificing part of your salary, whether it’s increased pension contributions, a cycle-to-work scheme, or another option.

3. Adjust Your Employment Contract: Your employment contract will need to be updated to reflect the new, reduced salary. This adjustment must be formalised in writing.

4. Begin Salary Sacrifice: Once everything is in place, your salary will be reduced by the agreed amount, and you will receive the chosen benefit in return.

Conclusion: Is it Worth It?

Salary sacrifice can be an excellent way to save on Income Tax and National Insurance Contributions while receiving valuable benefits such as pension contributions or a company car. However, it’s important to carefully consider the impact on your gross salary and how it might affect other aspects of your financial situation, such as eligibility for certain state benefits or future mortgage applications.

Before committing to a salary sacrifice arrangement, it’s advisable to seek advice from a financial advisor or tax professional to ensure that the benefits outweigh any potential drawbacks for your individual circumstances.