TECHTALK This article originally appeared in JUN 16 edition of techtalk. Please visit www.scottishwidows.co.uk/techtalk for the latest issue. NO SMALL SACRIFICE Thomas Coughlan In the run-up to the Budget in March 2016 many feared an attack on pension contributions paid via salary sacrifice. A groundswell of opinion whether justified or not had been building up that this advantageous method of funding for retirement would be removed. Fortunately, the concern was not justified with salary sacrifice once again avoiding the axe. And as an unexpected bonus, there was an encouraging comment in the Budget statement that salary sacrifice for pension contributions is viewed by the Government as acceptable, and will escape scrutiny in the forthcoming review of these arrangements. Employment benefits that come under the category of health benefits such as the cycle to work scheme will also be excluded. So, with one of the most positive Government statements on this type of salary sacrifice immediately behind us, now is a good time to look at how it works and why it is so beneficial.
WHAT IS SALARY SACRIFICE AND WHY IS IT ADVANTAGEOUS? Salary sacrifice involves giving up salary and receiving a non-cash benefit of equivalent value in its place. With this fundamental principle in mind, salary sacrifice is not the best description. Salary exchange is much better, but the industry seems to be sticking with sacrifice and so will I for the rest of this article. For an employee to agree to swap benefits in this way there has to be a financial incentive: the foregone benefit should be taxed at a higher rate than the incoming benefit. If it isn t, then the exercise is a pointless one, so a good understanding of the tax treatment of salary and pension contributions is required. We ll start with the taxation of salary, which is subject to two types of tax: income tax and national insurance contributions (NICs). Both are charged at 0% up to a point and then applied at different rates against bands of income as the following tables show: Income tax Band Rate Personal allowance Up to 11,000* 0% Basic rate band 11,001 43,000 20% Higher rate band 43,001 150,000 40% Additional rate band 150,000 + 45% * 1 of the personal allowance is withdrawn for every 2 of adjusted net income above 100,000 National insurance Rate Up to 8,060** 0% 8,061 to 43,000** 12% Above 43,000** 2% **annual thresholds A taxpayer with salary of 35,000 is, therefore, a basic rate (20%) income tax payer on their salary above the 11,000 personal allowance, and pays the top rate of NICs (12%) on their salary above the 8,060 threshold. If they make personal contributions to a personal pension plan, this will be paid out of their net salary. As the contribution is deemed to come from the top-slice of their income, it has been subject to 20% income tax and 12% NICs. Therefore, a contribution of net - which would be grossed up to 5,000 by the pension provider - would have required 5,882 of gross salary: Top-slice of gross salary less income tax @ 20% less national insurance @ 12% Net amount Net contribution to personal pension plus tax relief (at 20/80) Gross contribution to personal pension 5,882 ( 1,176) ( 706) 5,000 Salary sacrifice should be able to improve this tax position, either by increasing the amount paid in as a pension contribution or by improving the employee s take home pay whilst maintaining the same level of pension contribution. Starting with maximising the pension contribution: if the employee were to sacrifice 5,882 of their gross salary (i.e. the amount of pre-tax pay required to fund a personal contribution of net) and in exchange for this the employer pays 5,882 into the employee s pension, funding would increase significantly. The increase would be 882 or 17.6%, without any corresponding increase in tax elsewhere. The alternative approach which maximises take home pay may be more appealing. This method keeps the contribution to the pension scheme constant but improves the individual s personal tax position. In this case, only 5,000 of salary needs to be sacrificed for the employer contribution: the remaining 882 will be included in gross salary, resulting in an overall increase in the employee s financial position of 600, which is the net amount after deduction of 282 in tax ( 176 income tax and 106 NICs). The savings from salary sacrifice should be based predominantly on NIC savings, because employee pension contributions are paid from net income after deduction of income tax and NICs, but the income tax paid on those earnings should be repaid in the form of pension tax relief. There is no equivalent repayment of national insurance when a personal pension contribution is made. The employer contributions that salary can be exchanged for, however, suffer neither income tax nor NICs as employment benefits. WHAT ABOUT EMPLOYER NATIONAL INSURANCE CONTRIBUTIONS? So far we have looked at the savings that result largely from the employee NICs savings, but what about the employer NICs savings? These can be significantly greater, but whether they are available depends on the employer s willingness to pass them on. In some cases, the employer will keep those savings; in other cases, a proportion will be passed on; and some generous employers will give 100% of those savings up. We will look at the potential tax savings in each of these three scenarios. Example In previous tax years, Andrea a basic rate taxpayer had paid gross into her employer s group personal pension. At the start of this tax year she decided to take up her employer s offer of paying those contributions under a salary sacrifice agreement, opting to keep her take home pay constant and using the savings to enhance her pension funding. The contributions to her plan in 2016/2017 will be as shown below if her employer passes on 0%, 50%, or 100% of their NICs savings. As in the example above, to keep take home pay constant it is necessary to sacrifice the gross amount of salary that would have been required to be able to pay 800 net / gross as a personal contribution. This amount is 1,176, which would have reduced to 800 after deduction of income tax and NICs: 235 income tax and 141 NICs.
Example (continued) Retained NICs = ( 162) Contribution = 1,176 Improvement = 176 17.6% Retained NICs = ( 81) Contribution = 1,257 Improvement = 257 25.7% Retained NICs = ( 0) Contribution = 1,338 Improvement = 338 33.8% So an employer that passes on 100% of their NICs saving can substantially enhance their employees pension funding. An increase in contributions from to 1,338 taken every year boosted by fund returns could amount to sizeable improvement in retirement fortunes. But even where only part of the employer s savings is passed on, the improvement is noteworthy as shown in the middle column of the table above. When looking at the employer NICs savings from salary sacrifice, the recently introduced exemptions for certain employees must also be taken into account, as in some cases the employer won t benefit from the usual savings. There are two aspects to this: younger workers and the employment allowance. For 2016/2017 no employer NICs are payable on earnings up to 43,000 a year for all employees aged under 21 and for apprentices aged under 25. And the employment allowance is available to most employers, provided they meet specified criteria, and reduces their overall NICs bill by 3,000 in 2016/2017. For small employers, this could limit the extent of any employer NICs savings available via salary sacrifice. WHEN SHOULD SALARY SACRIFICE NOT BE USED? There are a number of scenarios when salary sacrifice is less effective, and whether it should be used is for the employer and employee to decide. There are also times when it must be avoided, which we ll look at now. THE NATIONAL LIVING / MINIMUM WAGE: The current Government enforces a national living wage of 7.20 per hour for employees aged 25 and over. The national minimum wage remains in force for those under age 25 and stands at 6.95 per hour for 21-24 year olds, 5.55 per hour for 18-20 year olds, and 4.00 per hour for those under 18 (rates apply from October 2016). These minimums must be adhered to, which prevents salary being sacrificed below these levels. Further, the minimum wage is applied as an hourly rate, so simply meeting the minimum as an average over a given period such as a year is not sufficient it must be met for each hour that the employee works. This prevents an employee from sacrificing all of their salary for a particular period - say a week or a month using the argument that whilst their pay was below the minimum wage for that period, taking the period as a whole the minimum wage requirement has been met. This is a surprisingly common question to the Scottish Widows Financial Planning Helpdesk. THE NATIONAL INSURANCE THRESHOLDS: In 2016/2017, employee NICs are due on annual earnings above 8,060 at the rates shown in the earlier table. Most employees, however, are paid on a monthly or weekly basis, and NICs are paid at these rates between the weekly / monthly equivalents of the annual thresholds. Employers pay on a similar basis to this: 13.8% on earnings above 8,112 (or the weekly / monthly equivalent of this threshold) in 2016/2017, however there is no lower rate of NICs above 43,000 the 13.8% rate applies to all earnings above the threshold. As salary sacrifice has predominately NICs benefits, there is little point sacrificing salary below these thresholds. However, in most cases the national living / minimum wage requirements will prevent sacrifice reaching down to these levels. HIGHER RATE TAXPAYERS The NICs savings for an employee sacrificing salary above the upper earnings limit is just 2%, however there is an income tax saving owing to the discrepancy between the income tax calculation on salary and the calculation of tax relief for personal pension contributions. The potential increase in retirement funding again keeping take home pay constant and based on a pre-sacrifice personal contribution of net is shown below. The amount of gross salary required to generate of net pay within the higher rate band is 6,897, which is x100/(100 40-2). Top-slice of gross salary less income tax @ 40% less national insurance @ 2% Net pay Plus basic rate relief (pension provider) Plus higher rate relief (self assessment) Total benefit 6,897 ( 2,759) ( 138) 6,000
If instead, 6,897 of salary is sacrificed and paid as an employer contribution, the improvement amounts to 897. The improvement in the employee s pension funding including varying amounts of the employer s NICs saving is shown below: Retained NICs = ( 952) Contribution = 6,897 Overall improvement = 897 15.0% Retained NICs = ( 476) Contribution = 7,373 Overall improvement = 1,373 22.9% Retained NICs = ( 0) Contribution = 7,849 Overall improvement = 1,849 30.8% The enhancement isn t quite as much in percentage terms as the basic rate taxpayer shown above, due to the reduced employee NICs due on earnings above 43,000, but there remains a significant improvement in the contribution even without the employer NICs savings passed on. An alternative approach, which enables pension contributions to be maximised without using salary sacrifice, must also be mentioned. This involves anticipating the reduction in the income tax liability when higher or additional rate relief is granted through self-assessment or an adjustment to the tax code. This route can only be followed when the scheme operates on a relief at source basis (e.g. personal pensions and stakeholders). If this amount is invested as a pension contribution, keeping take home pay constant, the overall contribution is enhanced, which will reduce the potential percentage gains available via salary sacrifice. Following on from the example above, the take home pay that the contribution is based on is. If instead of a net contribution of this amount, 5,333 is paid, the gross contribution will be 6,667. A higher rate taxpayer will then receive a reduction in their income tax bill of 1,333.33, which is 20% of the 6,667 gross contribution. The higher rate tax relief, therefore, reduces their net spend to ( 5,333-1,333), but their overall benefit has increased from 6,000 to 6,667. The potential improvements available via salary sacrifice when compared to this higher benchmark are correspondingly lower: Contribution = 6,897 Improvement = 230 3.4% Contribution = 7,373 Improvement = 706 10.6% Contribution = 7,849 Improvement = 1,182 17.7% LEGAL ASPECTS As salary sacrifice involves exchanging salary for some noncash benefit it can only take place when there has been a legally enforceable change to the terms of the employment contract. So both the employer and employee must agree to the change and it should be evidenced with a written agreement or addendum to the contract. Any subsequent change to the agreement should also be evidenced by a further alteration to the contract terms. However, it may not always be necessary to make such an amendment if the agreement states how certain events should be dealt with. These are normally termed lifestyle events and include things like marriage, divorce, redundancy and pregnancy and may allow the agreement to be temporarily suspended or opted out of completely. Each agreement will have its own terms so would need to be checked to determine how these are dealt with. Outside of this, employees should not be able to opt in and out of salary sacrifice agreements on an ad hoc basis. If they can, the sacrifice may not be effective for tax purposes. However, this restriction does not apply to all types of benefits that salary can be sacrificed for. The treatment of salary sacrifice by HMRC allows reversion to cash from certain types of benefits including workplace parking spaces, childcare vouchers and employer pension contributions, without the agreement failing for tax purposes. One of the main reasons for this applying to pension contributions was to ensure compatibility with automatic enrolment - in particular the opt-out process and the rule that prevents automatic enrolment being conditional on agreeing to salary sacrifice. The effect is that salary sacrifice for pension contributions can now be set up much more flexibly than was previously the case, but it remains prudent to evidence changes with a written agreement, and to check the wording of existing agreements to see what is allowed for. The benefits of salary sacrifice for employers and employees should ensure that it remains a popular planning strategy. Those that aren t aware of the tax savings should be directed to our numerous articles on the subject and the Scottish Widows Salary Exchange Calculator on the Adviser Extranet. And that the Government felt the need to specifically exclude salary sacrifice for pension contributions from the forthcoming consultation is an indication that, at least in the immediate future, it is unlikely to be withdrawn. Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given. Scottish Widows Limited. Registered in England and Wales No. 3196171. Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number 181655.