Updated 29 October 2020
A salary sacrifice scheme is an arrangement between you and your employer, where you give up or ‘sacrifice’ a portion of your salary in exchange for other, non-cash benefits. These can be things like childcare vouchers or a company car, but the most popular type involves additional pension contributions from your employer. If you’re exploring ways to boost your pension pot, a salary sacrifice pension scheme is one of the most common options. Here’s how these schemes work, and the pros and cons.
If you’re part of a workplace pension, you and your employer will contribute every month. The minimum your employer must contribute is 3% in the UK, though they can choose to contribute more.
One way to increase these contributions is via a salary sacrifice scheme. It means that contributions from your employer increase, except that they are really your own contributions, because your salary is proportionately reduced. However, the payments count as employer contributions, rather than employee contributions.
Reducing your salary in this way will reduce your gross (pre-tax) salary, but there are advantages to doing this for both you and your employer. Because your gross wages are now smaller, you’ll pay less income tax and National Insurance (NI) on your earnings. Your employer saves on National Insurance too.
Another good thing is that your take-home pay needn’t be any lower than if you were making the pension contributions yourself as employee contributions, because you choose how much salary to sacrifice.
How exactly does salary sacrifice boost your pension pot? This is what happens during the process.
Jane has a salary of £35,000 a year and contributes 5% into her pension, while her employer contributes 3%. That means Jane is contributing £1,750 and her employer is contributing £1,050 for a total contribution of £2,800.
Jane decides to sacrifice £1,000 of her salary, making her gross salary now £34,000. Her pension contributions stay at 5% of this, so reduce to £1,700 (you) while her employer’s 3% contribution is now £1,020. However, her employer also now contributes the additional £1,000 that Jane sacrificed. This brings the employer contribution to £2,020 to make a combined pension contribution of £3,720 – or £920 more than Jane’s pension would have received before.
In this example, Jane’s annual take-home pay would end up only £830 lower, so she has managed to increase her pension contribution by £90 more than she could have via the alternative method. (See below for more about how this is worked out.)
How much of your salary you can sacrifice depends on your current contractual arrangement with your employer. However, the amount cannot mean your salary falls below the minimum wage.
You should take great care when considering the amount, as it affects your future finances in several ways. Consider both your retirement goals and your pre-retirement goals, such as buying property – for example, a lower salary can reduce your mortgage options. It may affect some of your other earnings-related benefits as well, e.g. if your employer offers life cover or income protection insurance. A lower salary could also reduce the statutory maternity/paternity pay you’re entitled to, since it’s calculated on your earnings.
It’s important to understand all the areas your decision will affect – and to what extent – so that you can see if the advantages outweigh the drawbacks.
Sacrificing a portion of your salary is one way to grow your pension pot faster since your employer makes a higher contribution every month.
The tax and NI you pay is based on what you earn, therefore lowering your salary lowers your tax and NI contributions too.
The amount you sacrifice on your salary isn’t subject to income tax or NI contributions. This saves you a bit extra, since standard pension tax relief only repays income tax and doesn’t include NI.
Depending on how much salary you sacrifice, you might receive less cash in the bank each month. However, you can arrange it so that it’s no more expensive to you than making ordinary employee pension contributions.
Credit providers typically calculate how much you can borrow based on your salary. A lower figure might influence what mortgage you can get, for instance.
As mentioned earlier, lower earnings can influence the levels of your other benefits, including life cover or statutory maternity pay.
There isn’t a specific limit to how much you can sacrifice. However, your reduced salary has to remain above the national minimum wage. You also need to bear in mind that you can only contribute a total of £40,000 to all pension savings annually. This includes employer contributions, so ensure the higher contributions from your salary sacrifice doesn’t push you over this. It’s also helpful to check the minimum and maximum contributions allowed by your chosen pension provider.
Let’s go back the example of Jane above. Jane initially earns £35,000 salary and pays 20% income tax on her earnings above £12,500, and 12% on her NI contributions above £183. To work out how salary sacrifice impacts these payments, Jane needs to make the calculations based on her reduced salary.
Not using salary sacrifice
Using salary sacrifice
Jane’s salary: £35,000
Jane’s salary: £34,000
Jane pays £200 less income tax and £120 less NI every year
Take-home pay: £30,192
Take-home pay: £29,362
It is the law that every employer auto-enrols their employees into a workplace pension scheme, provided that those employees are between the ages of 22 and state pension age and earn a minimum of £10,000 annually. These employees are automatically placed into the scheme, with an option to opt-out.
Salary sacrifice pensions, on the other hand, are entirely at your employer’s discretion and joining them is up to you. It’s completely voluntary and you can opt-out at any time.
Your state pension is based on your NI contributions record. Because you pay less NI with a salary sacrifice scheme, this may impact your state pension. However, this is only likely to happen if your reduced salary means you’ll earn less than £183 a week, or beneath the threshold to make NI contributions.
The scheme is only available via employers, meaning self-employed people can’t have a salary sacrifice pension.
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