The government is keen to encourage people to save into private pension pots.
Because of this, some generous tax breaks are available. One of these, known as salary sacrifice, can even benefit the employer.
In this article, we take a look at salary sacrifice pensions and how they work, and answer a series of questions you may have about them.
Here’s what we cover:
What is a salary sacrifice pension?
Salary sacrifice is a way of notionally reducing a salary to pay for benefits offered by an employer.
These benefits are attractive to an employee, such as paying for an electric car, or using the Cycle to Work scheme to hire a bike.
Sometimes these are referred to as benefits-in-kind, or BIK. Some BIKs are taxed, but others aren’t.
Salary sacrifice can also be used for employee pension payments, and isn’t taxed.
To understand the benefits, we first have to discuss the existing way employees typically pay into their pensions.
Tax relief is already available on personal pension contributions. To make it simple, many employers offer a net pay arrangement.
This means the pension contribution is taken from the salary before tax is calculated, and so less tax is deducted from the pay. As a result, the employee receives tax relief on the pension contributions without having to do anything.
Salary sacrifice pension contributions are an alternative to the net pay arrangement that often works out better for both employee and employer.
It is also known as salary exchange, and, less commonly, SMART (Save More and Reduce Tax).
With salary sacrifice pension contributions, a new contractual salary is agreed by reducing the original salary by the amount the employee wishes to make as a pension contribution.
In exchange, the employer pays the same value as employer pension contributions on top of any existing employer pension contributions (e.g. a minimum of 3% as per auto-enrolment rules).
Because their salary is now effectively lower, employees not only potentially reduce the tax they pay—just like with the net pay arrangement—but also reduce their Class 1 National Insurance contribution (NIC) payments (and, as of 2023/24, payments for the Health and Social Care Levy).
The employee can use the reduced NICs to fund an increased pension payment, or reduce the cost of contributing overall.
Either way, it’s usually more beneficial than using the net pay arrangement, or the alternative relief at source arrangement.
Because employers also pay a separate Class 1 NIC (and Health and Social Care Levy contributions as of 2023/24), this is also reduced.
This saving is instant, with no requirement to claim it back at a future date.
On payslips, it can appear as if the employer has made one larger contribution, with the employee seemingly having contributed nothing.
Of course, this is not actually the case.
How does a salary sacrifice pension work?
There’s at least four stages involved in applying salary sacrifice pension contributions.
1. How feasible is a salary sacrifice pension?
Making salary sacrifice pension contributions isn’t suitable for everybody.
It can’t reduce the employee’s pay below the National Minimum Wage (NMW), despite what the employee might request.
Other regular or irregular deductions also need to be taken into account at this point to ensure that they plus the salary sacrifice don’t ever take the wage below this legal requirement.
Paying less than the NMW can get an employer in significant legal trouble.
Therefore, this is something employers will need to constantly monitor if an employee uses salary sacrifice (although this can be folded into ongoing payroll duties monitoring auto-enrolment pension criteria, such as whether younger or lower-earning staff become eligible).
2. Decisions for salary sacrifice pensions
Secondly, the employee must be in agreement that salary sacrifice should be used and that it doesn’t affect any statutory payments (see ‘Disadvantages for employees’, below).
Salary sacrifice pension contributions can’t be unilaterally imposed by employers, although they may default to such a system and ask the employee if they agree. This can be done during existing discussions around pension auto-enrolment.
If the employee disagrees (or simply opts out of the pension scheme) then it must be possible to work without salary sacrifice deductions.
If the employee agrees to salary sacrifice, they’ll also need to decide what percentage of their salary to give up as salary sacrifice (e.g 5%, 10%).
This may involve them calculating how much their gross pay will be reduced, and therefore how much they’ll save via lower income tax and NICs.
The employer will have to decide if they’re going to pass any savings they receive with regard to lower employer NICs (and Health and Social Care Levy as of April 2023) to the employee’s pension contributions.
Some employers look to pass on savings they may make after scheme costs, but it isn’t mandatory.
3. Adjusting the employment contract for a salary sacrifice pension
Thirdly, any existing employment contract needs to be adjusted to mention that the employee is in receipt of the benefit that is salary sacrifice pension benefit.
Usually, this is done by adding a clause to the employment contract, which is communicated to employees when they sign up for salary sacrifice, but employers should seek legal advice on the wording.
It’s worth noting that HMRC doesn’t usually allow employees to switch in and out of salary sacrifice more than once in a 12-month period unless there’s a major life event, such as marriage, divorce, birth of a child, and so on.
If you’re unsure, check with HMRC’s rules and guidelines.
4. Applying salary sacrifice weekly/monthly in payroll software
Finally, the payroll software must be configured so that the salary sacrifice is applied.
Not all payroll software is compatible with salary sacrifice, so employers should check with the software vendor.
Sage Payroll can be used for salary sacrifice pension contributions.
If salary sacrifice pension contributions haven’t been undertaken before, this will probably involve creating a new payment/deduction for salary sacrifice.
This will then be applied in the pensions setup area, with both the employer and employee contributions specified.
Then, during payroll, a new salary sacrifice line will appear for the employee, with the calculations automatically applied to the net salary amounts.
Advantages of a salary sacrifice pension
Everybody enjoys saving on tax and National Insurance contributions in a way that’s not only legal but encouraged.
HMRC didn’t touch the salary sacrifice pension arrangement when it clamped down in 2017 on tax relief for other kinds of salary sacrifice (e.g. benefits-in-kind schemes such as low-emission vehicles).
That’s as positive a thumbs-up as you’ll get.
Here are the specific benefits for employees and employers.
Benefits for employees
Employees get to boost their pensions via clever efficiencies in a way that’s more effective compared to alternatives.
Or they get to take home more pay.
For those paying into a pension later in life, when their earnings may be higher, salary sacrifice pension contributions offer a good way to make up for lost ground or poor pension performance by making larger payments without reducing take-home pay.
It’s also possible for employees to add a salary sacrifice bonus or additional salary payments.
Again, those paying into a pension later in life often put much or all of any yearly bonus straight into their pension to avoid paying tax on it, or to avoid pushing their salary into a higher tax bracket.
To stay on the right side of the law with regard to when a bonus is considered to be received, a decision must be made for the sacrifice of the bonus well ahead of time.
In practice, it’s typically done before the entitlement to the bonus is revealed.
Benefits for employers
Employers potentially get to save significant amounts on salary payments if they keep the NIC savings for themselves.
Furthermore, pension contributions are an allowable tax deduction.
So with effectively increased employer contributions, employers could save here too (although advice should be sought from a tax professional).
But employers need to look at the bigger picture.
Employees are increasingly aware of salary sacrifice, so employers that don’t offer it are at a potential competitive disadvantage when it comes to recruitment.
If the employer agrees to pass on their Class 1 NIC savings to the employee’s pension contributions then this can form another highly attractive recruitment factor.
Once again, the employee gets to boost their contributions with no loss of earnings.
This comes at no additional outlay for the employer compared to a non-salary-sacrifice arrangement.
Disadvantages of a salary sacrifice pension
As tempting as they are, it’s wrong to believe that salary sacrifice pension contributions are without issues.
And that’s something that should be considered ahead of time.
Here’s what you need to be aware of.
Disadvantages for employees
Employees need to take care that salary sacrifice doesn’t bring their salary below the lower earnings limit (£6,396 per year in 2022/23).
If that happens, it means they lose future entitlement to the likes of statutory sick pay, maternity pay, paternity pay, incapacity benefit, and more.
Furthermore, because the contractual earnings are now reduced, the level of borrowing the employee might be able to access could be reduced.
This can impact mortgages in particular. The likes of life assurance can also be affected when they’re set at a multiple of the contractual salary.
Disadvantages for employers
Employers face a potentially higher administrative burden around setting up salary sacrifice schemes and then maintaining them.
However, it’s possible to argue that this should be considered as part and parcel of any existing work performed for auto-enrolment pensions.
Notably, HMRC doesn’t usually take an interest in salary sacrifice pension arrangements by employers, but it’s wise to keep any documentation just in case.
Many businesses considering salary sacrifice discuss it via the HMRC helpline first, or get other professional guidance to ensure compliance.
The admin tasks for employers involve at least the following:
- Educating employees about the possibility of salary sacrifice. This includes the disadvantages mentioned above (although this can result in a win-win for both employers and employees if the latter agree to a salary sacrifice pension). However, your pension provider may have resources you can deploy.
- Providing a way to opt in or out, such as online, or by completing a paper form. Online forms often have a salary and pensions calculator to help employees make the best decision. When opting out, it should be made clear that this is opting in or out of salary sacrifice pension contributions and NOT auto-enrolment (although opting out of auto-enrolment automatically means giving up salary sacrifice, of course).
- Applying a correct employment contract clause for employees that opt in. Ensuring that it’s issued to employees, that they sign it by way of agreement and authorisation, and that this agreement is kept securely alongside other payroll record keeping.
- Monitoring employee wages that utilise salary sacrifice. This is to ensure the wage doesn’t fall below National Living Wage or National Minimum Wage levels (although payroll software might help with this and make this task easier).
Example of how a salary sacrifice pension works
Jane Smith earns £25,000 a year.
Her employer operates a basic auto-enrolment pension scheme where it contributes the minimum 3% employer contribution, while all its employees contribute 5% using the net pay system.
Using HMRC’s Class 1 NIC payroll checker calculator, we can see that before salary sacrifice, the monthly Class 1 NICs are as follows:
- Employer NICs: £199.46
- Employee NICs: £166.99
Following salary sacrifice of 5% of her earnings, and with Jane now contractually earning £23,750 a year, the monthly NICs are reduced as follows:
- Employer NICs: £183.78 (saving £15.68 per month)
- Employee NICs: £153.19 (saving £13.80 per month)
Salary sacrifice pension FAQs
Here are the answers to frequently asked questions about salary sacrifice in practice:
How much should your employees sacrifice for their pensions?
The auto-enrolment minimum of 5% employee contribution must continue to be observed.
Most employees sacrifice between 5% to 15%, depending on their circumstances and requirements with regard to pension savings.
What’s the limit to a salary sacrifice pension?
There’s no limitations on the maximum that can be sacrificed.
Although to maintain tax relief, contributions can’t exceed £40,000 each year for most people.
Can employees opt out of a salary sacrifice pension?
Salary must be a voluntary agreement between employer and employee.
Once underway, employees can opt-out, although HMRC may penalise the employer if this happens more than once in a 12-month period unless the employee has a good reason.
These include childbirth, redundancy of the individual’s partner, and other life-changing events.
Final thoughts on salary sacrifice pensions
Salary sacrifice pension contributions offer a lot for everybody involved, with very few drawbacks.
Whether it’s right for you and your employees is a decision that you’ll need to make, perhaps by discussing it with HMRC first, or getting other professional guidance.
These discussions should also help ensure compliance with legislation.
However, provided the limitations discussed above are observed, and assuming employers can spare the administrative capacity to deploy it, both employees and employers stand to gain without there being any pain.