Salary Sacrifice is a term to describe a situation where an employee agrees with the employer to give up his or her entitlement to normal paid salary, a bonus or pay rise in exchange for some non-monetary reward. The arrangements should ideally be tax-efficient so that both parties can potentially benefit.
Common examples of salary sacrifice
- Childcare vouchers;
- Employer contribution to a pension fund for the employee;
- Healthcare; and
- Company Car.
We have deliberately chosen some of the tax-favoured benefits first – let’s look at how a salary sacrifice works in a simple scenario.
Example 1: Childcare vouchers
Example Ltd decides to implement a childcare voucher scheme to all employees, based on the HMRC-approved model. Bob has a salary of £24,000 per year, so is a basic rate taxpayer, with young children in paid childcare. He could benefit from the vouchers, which are free of income tax and National Insurance contributions up to £243 per month. (The amount depends on whether the employee is a basic, higher or additional rate taxpayer on his or her salary). Bob and the company agree that he will give up some of his monthly salary, as follows:
Because he is paid less cash salary, Bob pays less tax and NICs, in fact he saves £77.76 per month or £933.12 a year!
However, the good news doesn’t end there because the vouchers are free of NICs, the company also saves money. In this example it saves £26.83 per month in effective reduced NIC costs – ample to offset any costs of running the scheme. The company stands to save £321.96 after tax, each year.
In the above example, while both parties end up better off, Bob has done far better out of the deal than has his employer. So, the employer could ask Bob to give up a little bit more salary, so that the benefits are more evenly shared. Alternatively, the employer can ‘break even’ and put its savings towards boosting the employee’s cash salary position, as the next example shows.
Example 2: Pension contributions
Martin is Head of Sales for Widgets-R-Us and has exceeded his annual target to increase orders by 10%. He negotiates a 10% bonus with his employer which, with an annual salary of £50,000, works out at £5,000. Martin’s employer warns him that, if his annual earnings in 2014/15 exceed £50,000 and he or his wife receives Child Benefit, then the government will ‘claw back’ some of that Child Benefit from Martin, assuming he is the higher earner.
Martin checks with his wife who confirms that, with two children under 16, she receives £1,771 in Child Benefit. Martin stands to lose 40% tax on his bonus as well as 2% NIC, and may have to pay back £880 to the government in clawed back Child Benefit!
Out of a bonus of £5,000, Martin stands to take home little more than £2,000 and is, understandably, very unhappy.
He discusses the position with his employer, and the company offers to pay the £5,000 plus an amount equivalent to its NIC costs into a personal pension fund for Martin which comes to a total of £5,690.
Assuming the pension contribution is tax-deductible, (they usually are), the company will be in the same position after Corporation Tax, whether it pays a £5,000 cash bonus to Martin, and suffers 13.8% Employers’ NICs thereon, or just puts £5,690 into Martin’s pension fund.
So, Martin can have just over £2,000 in his hand, or almost three times as much in a pension fund, at no extra cost to his employer. Of course, Martin has to be in a position where he can afford to live without his bonus: this option only works if he does not need the cash immediately. (It also assumes he has no other taxable income or reliefs, for simplicity).
In the above example, Widgets-R-Us quite generously offered to put its entire NIC saving into Martin’s pension pot. It could instead have offered just to pay £5,000, and kept the NIC saving for itself. In fact, as we said earlier, there is generally nothing to stop the employer from offering significantly less: even if the company had offered to put just £3,000 into a pension contribution, Martin would still have been significantly better off.
However, the employee may of course refuse a proposed salary sacrifice and insist on whatever he or she is entitled to under the terms of their employment. There is also a lower limit to what an employer can pay in cash form.
We have looked at two tax-favoured non-cash benefits which are commonly offered in exchange for salary sacrifice. The second example demonstrates just how beneficial the alternative can be for an employee and, potentially, the employer, depending on how the savings are shared between both parties. Although an employer may not necessarily know about an employee’s personal financial affairs, employees with combined salary and benefits which approach either:
- the £50,000 to £60,000 band where the child benefit clawback may operate, or
- the £100,000 to £120,000 band where the personal allowance is progressively reduced may find salary sacrifice proposals particularly favourable.
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