TECHTALK This article originally appeared in MAY 18 edition of techtalk. Please visit www.scottishwidows.co.uk/techtalk for the latest issue. THE BENEFIT OF SACRIFICE Following changes announced in 2016 and effective from 6th April 2017, salary sacrifice only provides a National Insurance saving for a limited range of employer provided benefits. Fortunately, this includes employer pension contributions. The other types of benefits that continue to be covered include the cycle to work scheme, child care vouchers and employer provided financial advice, but here we will focus on pension contributions. THOMAS COUGHLAN Tom has spent over 15 years in technical roles. He has wide experience including the provision of technical support to financial advisers covering life, pensions and investment compliance. He currently specialises in pension planning. 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. 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 replacement 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 11,850* 0% Basic rate band 11,851-46,350 20% Higher rate band 46,351-150,000 40% Additional rate band 150,000 + 45% * 1 of the personal allowance is withdrawn for every 2 of adjusted net income above 100,000 National insurance Rate Up to 8,424** 0% 8,425 to 46,350** 12% Above 46,350** 2% ** annual thresholds
A taxpayer with salary of 35,000 is, therefore, a basic rate (20%) income tax payer on their salary above the 11,850 personal allowance, and pays the top rate of NICs (12%) on their salary above the 8,424 threshold. If they make personal contributions to a group 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 4,000 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 5,882 less income tax @ 20% ( 1,176) less national insurance @ 12% ( 706) Net amount 4,000 Net contribution to personal pension 4,000 plus tax relief (at 20/80) 1,000 Gross contribution to personal pension 5,000 The same overall outcome applies when net pay member contributions are made to an occupational pension scheme. 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 enhancing the pension contribution, if the employee were to sacrifice 5,882 of their gross salary (i.e. the amount of pretax pay required to fund a personal contribution of 4,000 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 enhances 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 1,000 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 2018/2019 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 / 1,000 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. Amount of employer NICs saving passed on: 0% 50% 100% Salary sacrifice = 1,176 Salary sacrifice = 1,176 Salary sacrifice = 1,176 Employer NICs = 162 Employer NICs = 162 Employer NICs = 162 Retained NICs = ( 162) Retained NICs = ( 81) Retained NICs = ( 0) Contribution = 1,176 Contribution = 1,257 Contribution = 1,338 Improvement = 176 Improvement = 257 Improvement = 338 17.6% 25.7% 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 1,000 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. 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 2018/2019 no employer NICs are payable on earnings up to 46,350 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 2018/2019. For small employers, this could limit the extent of any employer NICs savings available via salary sacrifice. An employer that passes on 100% of their NICs saving can substantially enhance their employees pension funding. 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 7.83 per hour for employees aged 25 and over. The national minimum wage remains in force for those under age 25 and stands at 7.38 per hour for 21 24 year olds, 5.90 per hour for 18 20 year olds, and 4.20 per hour for those under 18. 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. Salary sacrifice can only take place when there has been a legally enforceable change to the terms of the employment contract. The national insurance thresholds: In 2018/2019, employee NICs are due on annual earnings above 8,424 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 8,424 (or the weekly / monthly equivalent of this threshold) in 2018/2019, however there is no lower rate of NICs above 46,350 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 5,000 gross is shown below. The amount of gross salary required to generate 3,000 of net pay (the 4,000 net contribution adjusted for the higher rate relief received) within the higher rate band is 5,172, which is 3,000 x100/(100 40-2). Top-slice of gross salary 5,172 less income tax @ 40% ( 2,069) less national insurance @ 2% ( 103) Net pay 3,000 plus basic rate relief (pension provider) 1,000 plus higher rate relief (self assessment) 1,000 Total benefit 5,000
If instead, 5,172 of salary is sacrificed and paid as an employer contribution, the improvement amounts to 172. The improvement in the employee s pension funding including varying amounts of the employer s NICs saving is shown below: Amount of employer NICs saving passed on: 0% 50% 100% Salary sacrifice = 5,172 Salary sacrifice = 5,172 Salary sacrifice = 5,172 Employer NICs = 714 Employer NICs = 714 Employer NICs = 714 Retained NICs = ( 714) Retained NICs = ( 357) Retained NICs = ( 0) Contribution = 5,172 Contribution = 5,528.5 Contribution = 5,886 Overall improvement = 172 Overall improvement = 528.5 Overall improvement = 886 3.44% 10.6% 17.7% 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 46,350, but there is still a reasonable improvement in the contribution even without the employer NICs savings passed on. LEGAL ASPECTS As salary sacrifice involves exchanging salary for some non-cash 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. Note: Scottish taxpayers have their own income tax rates and bands from 2018/2019 which will affect the tax outcomes in our examples. 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.