HomeWhether you call it salary sacrifice or salary exchange everyone seems to be talking about it, so how can it help your business and your employees? Are the benefits worth the effort? What are the pros and cons?
We thought we would take a look at salary sacrifice answering some of the main questions you will have, starting with the basics.
What is salary sacrifice?
The principle is very simple:
- An employee agrees to give up some salary or bonus
- The amount given up is used by the employer to provide a non-cash benefit to the employee, usually, but not always, a pension
- Because the employee is being paid less salary or bonus:
- the employer makes National Insurance Contribution (NIC) savings
- the employee pays less tax and NICs.
What are the benefits?
Making a saving on National Insurance or Income Tax is great but the benefit can be increased by considering various other ways in which the tax and NICs savings can be “spent”.
It is up to you, the employer, to decide what to do with the income tax and NIC savings. There are no hard and fast rules, however by using salary sacrifice correctly and introducing it sympathetically to your workforce, they could benefit from increased retirement provision or increased take home pay and you as the employer will be seen as providing these valuable additional benefits.
Some specific examples of the benefits
All of the following examples assume an employee earns £20,000 a year gross and both the employee and employer pay 5% of gross salary to a personal pension plan.
Option 1: Employee’s take-home pay increases, employer’s costs reduce, pension payment stays the same
| Before exchange | After exchange | Saving | |
| Employer costs* | £22,828.48 | £22,700.48 | £128.00 |
| Employee take home pay | £14,923.65 | £15,033.65 | £110.00 |
| Total gross pension payment | £2,000 | £2,000 | No change |
What’s happened? None of the income tax or NIC savings are reinvested into the pension plan so the pension payment stays the same. The employer does not reinvest their NIC saving so their costs reduce. The employee’s take-home pay increases as they pay no income tax or NIC on the amount exchanged.
Option 2: Employee’s take-home pay stays the same, employer’s costs reduce, pension payment increases
| Before exchange | After exchange | Saving | |
| Employer costs* | £22,828.48 | £22,680.07 | £148.41 |
| Employee take home pay | £14,923.65 | £14,923.65 | No change |
| Total gross pension payment | £2,000 | £2,159.42 | £159.42 |
What’s happened? The employee exchanges slightly more salary than 5% so that take-home pay stays the same. As more has been exchanged, this increases the pension payment. The employer does not reinvest their NIC saving so their costs reduce.
Option 3 Employee’s take-home pay increases, employer’s costs stay the same, pension payment increases
| Before exchange | After exchange | Saving | |
| Employer costs* | £22,828.48 | £22,828.48 | No change |
| Employee take home pay | £14,923.65 | £15,033.65 | £110.00 |
| Total gross pension payment | £2,000 | £2,128 | £128 |
What’s happened? The employer reinvests their NIC saving into the employee’s personal pension so their costs stay the same. The employee’s take-home pay increases as they pay no income tax or NIC on the amount exchanged.
Option 4: Employee’s take-home pay stays the same, employer’s costs stay the same, pension payment increases
| Before exchange | After exchange | Saving | |
| Employer costs* | £22,828.48 | £22,828.48 | No change |
| Employee take home pay | £14,923.65 | £14,923.65 | No change |
| Total gross pension payment | £2,000 | £2,307.83 | £307.83 |
What’s happened? All income tax and NIC savings are reinvested maximising the pension payment. The employee exchanges slightly more salary than 5% so that take-home stays the same. As more has been exchanged, this increases the pension payment. The employer’s NIC saving is reinvested
*Employer’s total costs include gross salary, pension payments and NICs
So, where can salary sacrifice be used?
It’s important to note that salary sacrifice can be introduced into an existing pension plan. Or, if an employer is considering setting up a new pension plan then introducing salary exchange at this time could prove cost effective.
Salary exchange can be offered to individual employees or selected groups of employees however, to benefit from the economies of scale, introducing it for all employees, for whom it is suitable, in a group pension plan makes sense.
Can salary exchange reduce state and other benefits?
Yes, salary exchange can affect certain employer, state and other benefits, some of which are listed below, please note that this list is not exhaustive. The impact on benefits can however be mitigated in certain circumstances.
Salary, overtime, bonuses and other employer related benefits
Although salary exchange is a reduction in gross salary, the agreement can be constructed so that salary increases, bonuses and overtime for example are based on the salary before the exchange. This is commonly known as “notional” or “shadow” pay.
Mortgages and other borrowing
Mortgage and other lenders may base the amount that they’re willing to lend on either a multiple of salary or affordability. Employers can provide lenders with details of an employee’s pre-exchanged salary however this may not be accepted. Employees considering borrowing should therefore discuss this with their lender or mortgage adviser.
Student loans
Repayments of student loans are triggered where earnings are currently above £15,000, although proposals are in place to increase this level. If a salary exchange reduces earnings to below this threshold then repayments may reduce or stop. This may mean that it’ll take longer to repay any student loan.
Basic State Pension (BSP)
The BSP is dependent on the number of contributions made in an individual’s working life rather than the amount of NICs. So provided an individual has at least 30 years of contributions, exchanging salary will not affect the level of BSP as long as the exchanged amount doesn’t reduce the individual’s earnings below the Lower Earnings Limit (LEL) for NICs.
State Second Pension (S2P)
S2P is an earnings-related benefit so you’d expect the S2P entitlement to reduce where an employee sacrifices salary. But that doesn’t apply in all cases:
Those earning less than the NIC LEL (Lower Earnings Level), £5,044 p.a. for 2010/2011, accrue no entitlement to S2P
Those earning between the LEL and the NIC primary threshold, £5,715 for 2010/2011, pay no NICs but get S2P benefits as though they were earning the
- Lower Earnings Threshold (LET), £14,100 for 2010/2011
- Those earning between £5,044 and £14,100 get S2P as though they were earning £14,100
- Those earning between £14,100 and £43,875 Upper Earnings Limit (UEL) get benefits based on actual earnings
- Those earning above £43,875 get S2P based on £43,875
Statutory Maternity/Adoption Pay (SMP/SAP)
SMP/SAP are based on gross earnings that are subject to Class 1 NICs and tax. As these earnings will reduce as a result of salary exchange, there’ll be an impact on SMP/SAP and they may also reduce.
It’s possible to avoid a reduction in SMP/SAP if an employee comes out of the salary exchange arrangement at least 23 weeks before maternity (or adoption) leave starts. The actual number of weeks will depend on the dates used by the individual’s employer. This would usually be done by exercising a ‘lifestyle event’.
If starting/stopping maternity or adoption leave is not an employer listed ‘lifestyle event’, SMP/SAP will be calculated using post-sacrifice earnings.
If the employer operates an occupational Maternity or Adoption Pay policy, they may increase payments up to or above the statutory amount to ensure the individual does not lose out.
Statutory Paternity Pay (SPP)
If earnings are reduced to less than LEL, there’s no entitlement to SPP.
Statutory Sick Pay (SSP)
SSP is a work-related payment which employees are entitled to by law and is not connected to their contract of employment.
If earnings fall below LEL then there’s no right to receive SSP. If this happens employees may still be entitled to income support based on incapacity or incapacity benefit, if they meet the qualifying conditions.
If the employer operates an occupational sick pay scheme, sick pay could still be paid through that scheme even if earnings are less than LEL to ensure employees are not worse off.
Tax Credits
The Working Tax Credit (WTC) and Child Tax Credit (CTC) were introduced in April 2003 to help families on middle incomes. The amount of WTC depends on a number of factors including the number of hours worked, how many children the employee has and the amount of eligible childcare costs.
Working Tax Credit is calculated on actual taxable earnings, so if these are reduced by a salary sacrifice, an individual’s WTC entitlement may increase.
Is it hard to set up?
Salary exchange is a change to the contract of employment and so there’ll be some paperwork required to set up an arrangement and it has to be done correctly. However, we have significant experience in this area and can implement a scheme with minimal disruption to your business.
We would take time to discuss with you the various things which need to be done to set up the arrangement and work with your other advisers to ensure it is set up correctly and with minimum disruption to your business.
Summary
There are clearly advantages and disadvantages to Salary Sacrifice, however for the right company and employee the benefits can be excellent.
In these difficult times any employer making the extra effort to provide increased rewards for his or her employees will be appreciated, the beauty of salary sacrifice is that it can be implemented at very little cost and offers the employee a real financial benefit.
To learn more about the benefits of Salary Sacrifice please do not hesitate to contact us.
