Case study: Salary sacrifice

It is worthwhile considering your clients who are likely to receive bonus payments throughout the tax year rather than just in the run up to the end of tax year.

The Government has chipped away at some of the benefits previously offered by employers through sacrifice of salary or bonus, but they are still a tax-efficient way of getting money into a pension plan. This is particularly the case if the employer is prepared to augment the salary/bonus given up by the National Insurance Contribution that it would have had to pay on it. 

To start the process, the sacrifice must be documented by way of a formal declaration by the employee to give up their rights to a future cash payment in return for the employer contributing to a registered pension scheme. 

By giving up the right to the cash payment, the employee obviously does not receive it and therefore does not pay tax on it. Neither would they be subject to the National Insurance Contributions on the amount given up.

Similarly, by making a payment as a pension contribution to a registered pension scheme for the employee, instead of as salary, the employer would also not be subject to their own employer National Insurance Contribution payments. 

HM Revenue & Customs (HMRC) should treat the employer’s pension contribution as a legitimate business expense for corporation tax purposes, as they would have the salary/bonus payment to the employee.

Salary sacrifice case study.

• Sandra is a high earner with a salary of £100,000 and has been awarded but not yet entitled to payment of a £10,000 bonus.
• As this bonus will push her into the earnings threshold where she loses £1 tax allowance for every £2 earned, she will suffer an effective tax rate of 60% on the bonus. She will pay a further 2% employee National Insurance Contribution, resulting in net cash in her hand of £3,800.
• Instead, her employer makes a £10,000 payment into her personal pension plan. It augments this by the 13.8% employer’s National Insurance Contribution it would have paid, had this been a salary/bonus payment. The total employer contribution to the pension plan is therefore £11,380. 

Taking this sum in isolation: if there was no growth on it up to the point at which Sandra draws upon it and any pension income payments fall into her 40% income tax band, she could receive: 

• Tax-free Pension Commencement Lump Sum (25%) = £2,845
• Income payment (£8,535 x 60%) = £5,121

​Sandra could receive a total of £7,966; more than double the net bonus given up. This sum could be higher still by factoring any tax-free growth within the pension plan, or if income payments fell into the 20% tax band. 

It is not only high earners that will benefit as demonstrated by this case study:

• Robert has a salary of £35,000 and has been awarded but not yet entitled to payment of a bonus of £10,000. 
• Income tax of 20% and his National Insurance Contribution (12% at this earnings band) will reduce his bonus payment and so his net cash in hand payment would be £6,800. 
• As in the previous case study, the employer could instead pay a pension contribution of £11,380. 

When Robert draws upon this sum, assuming income falls into his 20% tax band, he could receive the following: 

• Tax-free Pension Commencement Lump Sum (25%) = £2,845
• Income payment (£8,535 x 80%) = £6,828

Robert receives a total of £9,673, an uplift of over 42% on the net bonus he could have had instead.

Nevertheless, sacrificing salary or bonus could have disadvantages because of the lower amount of earnings. For example, it could reduce the amount that a mortgage lender would be willing to lend to the individual.  

You should take particular care when advising clients who could be subject to the tapered annual allowance. In these circumstances, salary/bonus sacrificed might still count towards the individual’s adjusted income, in which case their annual allowance would be reduced accordingly.