While employers and employees will not receive any additional income or corporation tax relief through using salary sacrifice, both will benefit from a reduction in their national insurance contributions
Salary sacrifice allows policyholders to boost pension contributions through savings on national insurance contributions, although there is no direct income or corporation tax relief benefit.
It is an arrangement whereby an employee agrees to a reduction in gross salary in return for their employer agreeing to contribute towards some other non-cash benefit, often a pension arrangement.
A typical example might be an employee who earns less than the upper earnings limit ' £30,940 in tax year 2003/04 ' who is considering contributing £1,000 of their income into a pension arrangement.
Normally, their employer would deduct the contribution that would qualify for tax relief. However, if they were to enter into a salary sacrifice arrangement, the employee's gross salary would be reduced by £1,000.
Although the tax saving for both parties is the same as if a contribution had been made to a pension arrangement, they pay less in national insurance contributions. The employee saves £110 (11%) and the employer saves £128 (12.8%). This is a combined saving of £238, a 23.8% increase in pension contribution that would not otherwise have been available.
If the employee's earnings exceed the upper earnings limit, the savings are not as dramatic but still worthwhile. For an employee earning, say, £50,000 who sacrifices £5,000, the combined employee and employer saving is £690, an increase in pension contribution of 13.8%. This is because the employee's national insurance contributions reduce to 1% of earnings above the upper earnings limit.
The amount paid to the pension scheme is treated as an employer contribution so, unlike AVCs or free-standing AVCs, the benefits arising under an occupational scheme from salary sacrifice can be taken as pension or tax-free cash.
Important changes have recently been made to the tax regime allowing more flexibility for those using salary sacrifice.
The key change is in relation to the treatment of bonuses. In the past, if a bonus was to be sacrificed, the employee had to enter into a sacrifice agreement with their employer before the amount of the bonus was even known. This made the choice between taking a bonus as taxable income or sacrificing it to reduce tax and national insurance contributions more difficult.
Now the choice can be made after the amount of the bonus is known, provided the agreement is set up before the due date of payment.
A further technical change is that it is no longer necessary to document the salary sacrifice separately from the employer's contribution to a pension scheme, making the lives of pension scheme administrators much easier.
It is important to remember that salary sacrifice constitutes an amendment to the employee's contract of employment so any reduction in salary should be agreed in writing by the employee and employer.
Since a salary or bonus must be given up before it is treated as received for income tax or national insurance contribution purposes, the date of the agreement can be crucial. Care is needed when applying this relaxation to company directors, for whom the rules are slightly more restrictive.
A salary sacrifice arrangement will be ineffective if the employee retains a right to the remuneration. All that is happening is that the employee is mandating the employer to pay a fixed amount of their remuneration to a pension arrangement. The amount involved would then be treated by the Inland Revenue as an ordinary employee contribution, so causing the whole object of the exercise to fail.
A salary sacrifice of £5,000 or more, where the pension arrangement is an occupational scheme, must be notified to the employer's schedule E tax district. The local inspector will then decide if the salary sacrifice is effective. If it is decided it is not, the Inland Revenue's Savings, Pensions, Share Schemes division will be notified. This notification is not required when the contribution is to be made to a group personal pension or stakeholder scheme.
One point that is often overlooked is the fact that once earnings have become payable, they cannot then be sacrificed. Salary sacrifice only applies to future earnings. If only basic salary is involved, this should not cause any problems.
There are potential disadvantages to salary sacrifice. Taking a reduction in salary can impact benefits that are salary-related, as shown in the box above.
The increase in national insurance contributions makes salary sacrifice more attractive to employees, especially if the employer is prepared to apply the saving as an additional pension contribution.
It was never clear why the Inland Revenue felt it was necessary to keep reference to the employer's pension contribution separate from the salary sacrifice agreement. The removal of this artificial divide is to be welcomed.
Of much greater significance is the fact an employee's bonus can be given up after the amount is known but special care is needed with directors, whose bonus cannot be given up if the amount has already been determined.
Looking to the future, salary sacrifice could become increasingly popular if the Inland Revenue's recent simplification proposals come into effect as indicated in its consultative paper. One of the current drawbacks, when benefits under an occupational scheme and contributions to a personal pension scheme are linked to earnings, would be removed if the Revenue goes ahead with its plans for the introduction of a lifetime limit.
Salary sacrifice only applies to future earnings. Once they have become payable, they cannot be sacrificed.
Taking a reduction in salary can impact benefits such as permanent health insurance and social security payments.
The introduction of a lifetime limit would make salary sacrifice more popular.
Salary sacrifice allows policyholders to benefit from reduced national insurance contributions made by themselves and their employers.
Changes to the tax regime allow more flexibility in the way salary sacrifice can be applied to bonuses.
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