Salary Sacrifice

Salary sacrifice is basically a scheme in which employees sacrifice part of their salary to make contributions to a benefit, such as a group pension. This contribution then leads to a real-world uplift in value, thanks to savings made in tax and National Insurance. Because these savings add up to a higher-value contribution, perception of the benefit improves, along with take-up rates.

What is salary exchange?

A salary sacrifice or salary exchange takes place when an employee gives up the right to part of the cash remuneration (salary) due under the contract of employment. Usually, the sacrifice is made in return for the employer's agreement to provide the employee with some form of non-cash benefit, such as a contribution to a pension scheme. The sacrifice is achieved by varying the employee's terms and conditions of employment relating to remuneration.

Why does that save tax and NICs?

Certain non-cash benefits can be provided to employees without attracting tax or National Insurance charges. The primary examples are:

Pension contributions
Childcare vouchers
Bicycles, under cycle-to-work schemes
Workplace parking

How much are the savings worth?

For basic-rate taxpayers sacrificing salary for pension contributions, the savings in tax and national insurance mean the pension contribution can be increased by a minimum of nearly 16%. If the employer agrees to add their own savings in employer's national insurance, the pension contributions can be increased by nearly 31% in total. The example below shows how this works.

Example of the benefits of salary exchange - £80 monthly net contribution

Scenario 1 - No salary exchange – basic rate taxpayer

The monthly pension contribution has basic rate tax (20%) added to it to achieve a gross contribution of £100 per month.

Scenario 2 – Salary exchange – basic rate taxpayer.

The employee sacrifices £115.94 of gross pay per month. This gross pay is worth £80 of net pay to the employee after deductions of basic rate tax (20%) and national insurance (11%). So the employee sees the same reduction in net disposable income of £80.

The employer contributes the sacrificed salary of £115.94 to the employee's pension. The result is that the pension contribution increases by £15.94 or 15.94%. This increase comes because there is no longer any employee national insurance charged on the sacrificed salary.

At the same time, the employer sees a saving of £14.84 in employers national insurance (12.8% of the sacrificed salary). The employer may decide to retain this money, to deploy it elsewhere in providing benefits or to add all or part of it to the pension contribution. Adding all of it to the pension contribution will result in a total pension contribution of £130.78 - a 30.78% uplift compared to the pre-sacrifice position.

For an employee earning £25,000, a contribution of 3% would cost £50 per month of net pay to achieve a £186 pension contribution!

For higher rate taxpayers savings can also be significant, although the uplift from saving employees national insurance is more limited because higher rate taxpayers only pay national insurance at 1% on earnings over £43,875 per year (2009/10 levels). However, an ancillary benefit for higher rate taxpayers is that higher rate tax relief on contributions no longer needs to be claimed in the year-end tax return.

Bonus Exchange

The option to exchange bonus payments for single pension contributions may also be offered to scheme members. This would benefit from the same uplifts in the value of the contribution.

Why doesn't it work well for other non-cash benefits?

Other non-cash benefits may save on employee national insurance contributions but are still subject to tax and employer national insurance (Class 1A) contributions through the P11D reporting process. Private medical insurance premiums are a good example. These can be paid by the employer and recovered through salary sacrifice. However, a P11D must be completed for the employee and the cost of the benefit would be taxed. The employee would save on their national insurance contributions, albeit only at the rate of 1% for higher rate taxpayers.

What's HMRC's stance on salary sacrifice schemes?

Because salary sacrifice is an employment law matter, involving a variation in the terms and conditions of employment, HMRC is interested only in determining the consequent tax and NICs liabilities. It does not have a view about whether such arrangements are good or bad for employees in principle.

HMRC will not advise on setting up salary sacrifice schemes, although they will confirm whether the correct tax treatment is being made for arrangements already in place. Accordingly it makes sense for new schemes to be set up on a very limited basis initially in order to obtain HMRC's confirmation, before rolling them out to the wider employee base.