Many Monevator readers will be reaping generous tax breaks on their pension contributions made available through salary sacrifice schemes.
But what’s less widely understood is that salary sacrifice can work against you if it lowers your salary below critical thresholds, or if your employer hasn’t been transparent about what your salary officially is.
Badly administered schemes operate in a grey area that leaves employees in the dark about potential downsides – such as the risk of reduced redundancy pay, sick pay, and other benefits – whether by accident or unscrupulous design. (Delete as applicable, although we can do without either in the midst of a worldwide recession).
What is salary sacrifice?
Salary sacrifice schemes are a contractual agreement between you and your employer to give up part of your salary in exchange for a non-cash benefit such as pension contributions, childcare support, bicycles, and ultra-low emission cars.
The upside is you do not pay tax or National Insurance Contributions (NICs) on your foregone salary.
Your employer doesn’t pay National Insurance on your sacrificed salary either. They can pass on their savings on to you, or they can sneakily trouser it for extra profit.
HMRC doesn’t seem to mind a bit so long as certain boundaries are observed.
What is the downside of salary sacrifice?
The downside of salary sacrifice is that it lowers your salary – and you’ve signed a contract saying that you agree to it!
Reducing your salary can reduce your entitlement to a slew of benefits that are related to your earnings level, including:
- Redundancy pay
- Notice pay
- Pay rises
- Overtime and bonuses
- Holiday pay
- Sick pay
- Employer pension contribution levels
- Life cover
- Maternity / paternity pay
- State Pension
- Unemployment benefits
- Incapacity benefit
- Mortgage borrowing levels
- Credit card borrowing levels
All of the above depend on your earnings level to some degree – or to your earnings clearing certain thresholds.
Your employer is under no obligation to measure those benefits against your pre-sacrifice salary (unless they’ve contractually agreed that with you).
In some cases it’s entirely out of their hands anyway. You shouldn’t be on a salary sacrifice scheme if it drops you below the National Minimum Wage (unless you’re exempt). It may also not work out for you if you’re subject to the tapered annual allowance. Hint: HMRC are alive to this caper and sacrificed salary is just added back to calculate your threshold income. It’s like shooting at the Borg.
Salary sacrifice: how it could cost you
Everything is okay if your employer clearly explained the issues to you before you signed your new contract sacrificing salary.
(Yes… of course they did.)
Alternatively, everything is groovy if your employer is completely trustworthy and not prone to doing over its own employees when cashflow is tight.
(Is it just me, or is it suddenly a bit hot in here?)
Things are still on a relatively even keel if your employer explained that you would retain a notional salary or shadow salary. In this case your pre-sacrifice salary counts when your employer calculates your right to contractual benefits that it controls, namely:
- Redundancy pay
- Notice pay and holiday pay
- Pay rises
- Overtime and bonuses
- Contractual sick pay
- Employer pension contribution levels
- Life cover
- Contractual maternity / paternity pay
If you don’t have a notional salary agreement then employers are perfectly within their rights to use your lower post-sacrifice pay to calculate these amounts – although they should have mentioned it before signing you up to salary sacrifice. I say they’re within their rights – obviously you work for ScuzzBucket plc if your employer does this kind of thing… can I interest you in a prospectus?
State benefits are calculated using your post-sacrifice salary and that’s the end of it. These include:
- Statutory sick pay
- Statutory maternity / paternity pay / adoption pay
- State Pension entitlements
- Incapacity benefit
- Parental bereavement pay
- Jobseeker’s Allowance and Employment and Support Allowance
You can ensure you don’t come a-cropper with some of these benefits (such as State Pension) by ensuring your salary doesn’t drop below the lowest threshold for National Insurance Contributions, or that you’ve built up a sufficient record of payments already or through credits.
A particularly generous employer can make a non-statutory ‘top-up’ payment to employees, if they’d like to make good any shortfall in statutory pay entitlement.
(Good luck with that!)
Salary sacrifice: can I change my agreement?
You can change your salary sacrifice agreement, but your freedom of manoeuvre is limited.
Your contract should specify your cash earnings and your non-cash benefits. Non-cash benefits are benefits that your employer pays for.
Your contract needs to change whenever your salary sacrifice agreement changes, and if you switch between cash and non-cash benefits too frequently then you lose your tax advantages.
The Government has outlined certain ‘lifestyle changes’ which justify a swift opt-out of your salary sacrifice agreement.
Example events include:
- Changes to circumstances directly arising as a result of coronavirus (Covid-19)
- Marriage
- Divorce
- Partner becoming redundant or pregnant
It’s also worth noting that your employer can’t force you into a salary sacrifice scheme, just in case you were wondering.
Salary sacrifice: does it reduce my pension annual allowance?
Salary sacrifice should not have any negative impact on your annual allowance although, as always with tax, seek more qualified advice if you’re worried about this.
The problem goes something like this:
- Your pre-sacrifice salary: £40,000
- You salary sacrifice: £25,000
- Your post-sacrifice salary: £15,000
Does that post-sacrifice salary limit your annual allowance to £15,000 (less than you’re contributing!) because your tax relief is limited to 100% of your relevant UK earnings per tax year?
(I’m excluding those who’ve triggered the money purchase annual allowance (MPAA) or the tapered annual allowance.)
Your £40,000 pension annual allowance for defined contribution pensions consists of:
- Your personal contributions
- Your employer’s contributions
- Third-party contributions – anyone else who kindly chips in for you
If the combined total of those contributions goes over your annual allowance and your carry forward, then you’re in for a tax charge.
You get tax relief on your personal contributions up to 100% of your relevant UK earnings or your annual allowance, whichever is lower.
Your employer’s contributions are not subject to your relevant UK earnings limit, only your £40,000 annual allowance limit.
Old Mutual puts it succinctly:
Personal contributions can be limited by relevant UK earnings but employer contributions are not.
Meanwhile, salary sacrifice converts your salary into an employer pension contribution as explained by Pru Advisor:
An employee could also save income tax, and National Insurance Contributions (NIC), by using a salary sacrifice agreement.
This is where they have a contract with their employer to exchange some of their gross salary (before tax) for a non-cash benefit, such as an employer pension contribution.
So it’s okay if salary sacrifice reduces your salary below the level of your total pension contributions – because your sacrifice is classified as employer contributions, and those do not attract tax relief.
However, personal contributions above your post-sacrifice salary will not gain tax relief either.
All of this is apparently confirmed by the Government’s own pension annual allowance calculator which does not ask how much you earned during the tax year. It’s only interested if you exceeded the £40,000 limit or if you tripped the MPAA or tapered annual allowance.
Salary sacrifice in a crisis
I’ve been happily maxing out my salary sacrifice for years in order to hit financial independence. I didn’t know about the downsides, nor was I made aware of them when I signed up.
That makes me deeply uncomfortable about what will happen should I catch a bullet. Maybe it’ll be alright, maybe not.
I don’t like grey areas and – given we face a recession of biblical proportions – I’ve cut my salary sacrifice to the bone.
Take it steady,
The Accumulator
This is an eye opener…. thanks.
I was made redundant last year, and luckily my employer paid out taking my notional salary into account. Am presuming my current employer would also; they don’t pocket their NI savings, they add it to the pension contribution. But definitely worth checking this and the other stuff you mention!
Once again, the devil is in those pesky details! Every time there is a crisis some new learning occurs. Iirc, the GFC brought what is now known as the FSCS (I think) protection limit to most peoples attention.
Very timely given the number of redundancies these days.
Is it fair to summarise you can give up 50% of your gross salary to SS as long as you are earning under £80k?
Another who has “enjoyed” the benefits of salary sacrifice to help with growing my pension for a number of years now, it’s always interesting to read the potential gotchas as it seems to be generally little known or described. Although I have a few years worth of running costs in cash-like savings, situations like the current one always make me wonder if I have the right balance between cash is king and taking advantage of investments being on discount. So far lethargy has got the better of me.
I used salary sacrifice to increase pension contributions and was recently terminated via a Settlement Agreement. Whilst i was aware of the potential gotchas in doing so with benefits , and don’t believe any share of NI was made, it was beneficial to minimise amount of exposure to higher rate tax.
I had never considered that any amount sacrificed would be taken into account when termination calculations were made …they weren’t ..and a surprise to learn here that this could theoretically be applied by a mean Employer. I thought it was all about a calc. against external HMG metrics.
@TA , interested to know which potential disbenefit trumped your presumed tax advantages of pension saving via sal sac …as had I still been in work i don’t think i would have felt that anything justified not continuing to save just under 30% of salary into pension.
@hyperhypo – it’s a very personal calculation but I’d front-loaded my pension savings over the years. My ISA bridge: not a priority. As coronavirus loomed I could carry on salary sacrificing into pension and building cash ISA in parallel or make a dash for cash. Something like:
ISA cash + large salary sacrifice = both goals met in 12-months
Max ISA cash + min salary sacrifice = ISA bridge filled in 6-months. Finish off pension after that. (The timescales aren’t accurate, btw, this just gives you the gist).
Cash is king for me right now given I don’t know how long the job will last. Seems like a good time to have an extra large emergency fund / dry powder / complete the ISA bridge while at the same time minimising exposure to salary sacrifice vulnerabilities.
The calculation is a very personal one – weighing up my ISA / Pension targets, distance to finish line, job insecurity, age etc
I wouldn’t worry about this too much
If you can make it through to the next budget in your job I expect salary sacrifice schemes will be one of the first pension saving tax breaks to be axed to decrease the budget deficit
The first of many
Just a quick(ish) comment on benefits. These can broadly be categorised into three:
1) Those reliant on NIC’s;
e.g New Style JSA (payable for a maximum of 6 months), New Style Employment and Support (payable for 12 months if in the Limited Capability for Work group), and (of course) the State Pension.
2) Means Tested Benefits;
e.g Universal Credit, Council Tax Support, Pension Credit.
3) Benefits paid because of specific circumstances;
e.g Child Benefit, Personal Independence Payment (PIP) which can help with the extra costs resulting from a long term ill-health or disability.
(Incapacity benefit was merged into ESA some years ago).
https://en.wikipedia.org/wiki/Incapacity_Benefit
Here is some info on eligibility for New Style JSA and New Style ESA :
https://www.entitledto.co.uk/help/employment-and-support-allowance-contribution-based
Earnings in each of the two previous tax years would need to be c. £5,900 to be eligible.
So providing salary sacrifice had not taken earnings below that level, it should be possible to claim either New Style Job Seeking Allowance or New Style Employment and Support Allowance on the basis on NI contributions.
Note that ESA can be paid if someone has been assessed as not fit for work due to an illness or disability, it totals c.£74 a week.
https://www.gov.uk/guidance/new-style-employment-and-support-allowance
Sorry – not so quick after all. Benefits can be complicated (and are forever changing).
While many of the stated concerns in this article might be genuine, it really boils down to the employer’s trustworthiness, and not with the salary sacrifice in itself. I have been under a salary sacrifice scheme with three different employers, for over 15 years, and there has always been a clear difference between my payroll salary (post-sacrifice) and my gross salary (pre-sacrifice). Every time I have had a bonus, have requested a reference letter for mortgage applications, every pay rise, and indeed the terms of my life insurance, are all done on the basis of my gross salary. With every employer. I have not had the misfortune of being made redundant, but I have colleagues that have, and their redundancy payment (statutory as well as voluntary settlements) have also been done on the basis of the gross salary, pre-sacrifice.
So, while a shady employer might take advantage of salary sacrifices by tricking the employee into giving up some of their rights, I think the vast majority of employers don’t do that.
In short, this article is taking an undue alarmist point of view, and disparaging a truly beneficial scheme which provides about the only useful tax optimisation tool available to PAYE employees. If there have been any instances of abuse where employees have truly lost redundancy pay or benefits due to salary sacrifice, is it much to ask to provide some evidence?
@Neverland. I fear you may be correct about salary sacrifice and/ or higher rate tax relief for pensions, I’m using cash saved from no commuting, car parking, eating out & holidays to salary sacrifice as much as possible at the moment. Seems I have a decent employer as they pass on their full Employer NICs Savings and any redundancy payment etc based on notional salary.
@ Dingo – the piece isn’t intended to criticise salary sacrifice or be alarmist at all. It is intended to make sure that more people are aware of the facts and the potential for ‘gotchas’ as C put it.
I’m glad you have enjoyed a run of scrupulous employers but I don’t think it makes sense to extrapolate a general position from your personal experience. It’s clear that there are:
1. Unscrupulous employers
2. Employers who are ethically inconsistent, especially in extreme circumstances.
3. Scrupulous employers who are taken over by less scrupulous ones: where a previously trustworthy relationship and unwritten promises can no longer be relied upon.
The most important thing is that people should know where they stand and what they should ask of their employers. The position certainly wasn’t made clear to me but, as ever, caveat emptor!
@Dingo
Companies have a duty to maximize the value for their shareholders.
Indeed as shareholders most of the posters here expect nothing less.
In a situation where many companies are fighting for their survival and are/will be laying off over half their staff why would they provide non-contractual benefits to employees they are firing?
Practically its actually extremely time consuming and expensive to take a former employer to employment tribunal for breach of contract under the current UK employment legislation
Im not sure you even can easily sacrifice yourself below state benefit limits, due to minimum wage, the only way you could do that is if you were a part time worker paid above minimum wage. And in fact minimum wage can be an obstacle if it stops someone paying for childcare by sacrifice – forcing them to still pay NI at 12% if they as a family still earn too much for UC. Minimum wage looks and smells like more of a protection for HMRC than for workers.
That said I wonder how minimum wage sits with auto enrollment? Do former minimum wage employers now pay a tad more to sacrifice into the auto enroll or do employers pay the whole minimum themselves?
Furlough is an example of payment based on after sacrifice salary. So earn 3k a month, sacrifice 1.5k can only get 80% of 1.5k.
One thought though. The employees likely to be caught up in serious salary sacrifice where this becomes a material worry are likely to be better paid and better experienced / qualified. These sorts of people are likely to have company secrets and other sensitive knowledge. Plus many industries are surprising small knit at this level (people know each other, people end up working for competitors etc). So while maximising shareholder value, I doubt many companies (unless on the cusp of bankruptcy) would play by such dirty tricks. It would hurt their reputation and risk secrets getting out there (esp if large numbers leave, who do you go after). Plus you often want to pay these people off as you know they are the ones who can afford to go to tribunal etc and make life hard / expensive for the employer.
So while I wouldn’t ignore the warnings and make sure you are comfortable with your employers position, I wouldn’t worry too much. Though maybe these will be famous last words….
I pared down my salary sacrifice in March to the minimum employee contribution to get the maximum employer contribution, and together with lower lifestyle spending during lockdown have topped up my cash reserves.
This isn’t a cash out my chips panic, but a cautious response to a major crisis. Having changed jobs in December ’19, redundancy payments weren’t part of my calculation.
In the list of risks/downsides, not just redundancy and notice pay which would, unless the employer voluntarily bases on the pre-salary sacrifice level, be reduced. Also AFAIK general employment statutory compensation on dismissal awarded by an Employment Tribunal (and what you’d expect an employer to base on in a Settlement Agreement). Not just redundancy, any type of unfair or unlawful dismissal. What is known as the compensatory award is based on net lost earnings. That would use the actual reduced salary, not the previous notional salary contractually foregone. Depending on what you’re swapping it for, it may or may not make any difference overall to an award of compensation (eg if you were exchanging for higher pension contributions). But worth bearing in mind and checking at the time, particularly if there are concerns around job security, whether the organisation’s position, or you and your boss don’t get on (which underlies many departures).
As a Compensation Specialist, I’ve never come across a company that would be purposefully utilising someone’s salary after salary sacrifice for the list of things mentioned in this article. Statistically that of course doesn’t mean much but what I am trying to say is that that would be very, very poor practice and I’ve never even heard it mentioned (and as someone who works in the Human Resources department, I have heard/seen some shocking things).
I like the idea of bringing awareness to what salary sacrifice is and making an educated decision but my comment would probably be that worrying the employer is going to use your post-salary sacrifice salary when calculating your sick pay or bonus shouldn’t be up there as your main worries. If the business was going to do that, chances are there would be lots of other dodgy stuff happening as well.
I’m in same boat as hyperhypo – salary sacrifice wasn’t detrimental when it came to the crunch.
It was good while it lasted, I was sacrificing 70% for a good few years and got the employer NICs
I don’t believe that the relevant UK earnings bit is applicable in salary sacrifice. It’s no longer ‘tax relief’ – it forms part of an agreement with the employer to put an employer contribution into a tax deferral wrapper.
I take my ~60k salary down to ~25k via sal sac, which with the generous employer contribution and their NI saving passed to me, nets me the 40k limit into my pension.
This also means my earnings qualify us for benefits. As well as the obvious child benefit coming back, if you rent and have kids then it qualifies you for universal credit too, Not doing this means a effective marginal tax rate of ~75%.
It might be an unpopular opinion, but there is no point in earning 60k, rent and have kids if you don’t do this. You might as well earn 25k, because of that horrendous effective marginal tax rate.
My other benefits are all calculated on gross salary.
I really struggle to understand the logic of people targeting early retirement putting anything into pensions. Yes, the UK tax breaks for this are generous. However, let’s say I am 35 so I need wait, depending on scheme’s T&Cs, 25-35 years to access these savings. However, what’s the use of that to me if want to early retire in 45 years… So many things may change in 25-35 years, there may be so many emergencies for which even 2-year cash emergency fund would not be enough…. So I would certainly prefer to:
0) get at least one year emergency fund;
1) maximize my ISAs (instant access if needed + the same growth as pensions);
2) form a stable monthly income from a mix of stocks, property and other investments;
3) only then, if I am still working, I can putting my whole annual allowance in the last years of work into the pension…
What am I missing? I just can’t see the appeal of pension breaks if you need to wait for them until you are 65…
@Leo — Hi, not sure if you’re a new reader (I see this is your first comment) but this multi-part series might explain some of the logic.
Basically it’s not either/or.
https://monevator.com/how-to-maximise-your-isas-and-sipps-to-reach-financial-independence/
I have used salary sacrifice to great effect over the last 4 years or so but was amazed that to qualify for a mortgage of 1.75 our joint income (ignoring investment returns like dividends or bonuses) but 4 times our apparent after SS / sharesave / pension pay.
So I needed to reduce SS to bring up my take home pay. Coat me a few hundred / thousand quid in extra tax a month.
Why when i had given them proof of coktractual salary and despite having to also produce payslips and bank statements?
Once the mortgage was approved up went the sacrifice again to bring me down to the nmw but it was sad that “computer says no” in these situations.
It doesn’t make sense to me but.that’s modern lending practices it seems.
@GFF – I Went through L&C and found it varies from provider to provider, so for sure it can be a real spanner in the works if you’re looking to borrow. If I remember correctly Santander were post SS but Scottish widows who I ended up using went on gross. There doesn’t seem to be any rhyme or reason to it. I think edge cases like this are much more needing of consideration than dodgy employers. CEO who booted me was mad as a march hare. Young earth creationist and rampant islamaphobe, but even he played a straight bat w.r.t SS, didn’t even stiff me on the last of the employer NICs. I think fear of tribunals looms pretty large
Salary sacrifice can be a great option if you are aware of the system rules. I’ve been using Salary Sacrifice for the past 3 years. I had some pension carryover so I’ve been sacrificing as much as possible, my employer also pays half the employer’s NI into my pension. Before entering into the scheme I had a long discussion with payroll to address many of the points the article listed. I had previously considered using salary sacrifice to “game” the UK benefit system as comment 19 mentioned. However, under the new Universal Credit system that option no longer exists if you breach the savings threshold. If I didn’t use Salary Sacrifice my household would lose child benefit and I’d be a higher rate taxpayer. I suspect some may see my use of Salary Sacrifice as a tax dodge but in reality I’m deferring taxation.
Great post. I just selected my annual benefits yesterday so might revisit to see how they’ve been structured and how it may impact mortgage borrowing limits as I’m aiming to buy a place at the end of next year. I hadn’t even thought of this implication, so very timely!
Thank you so much for this article, I’ve been trawling through goverment and pension advisory websites and could not get a clear answer on how salary sacrifice interacts with the annual allowance. I wanted to make use of the annual allowance from previous year but wasn’t clear if I could do that since I was no longer “earning” enough to get the tax benefits. Your section “Salary sacrifice: does it reduce my pension annual allowance?” answers this perfectly. Fantastic work!
Hi techie – I’m glad it helped. Good luck with it all!
Great article, I’ve worked in the industry for nearly 20 years now and most employers and employees aren’t aware of the technicalities.
If it helps reassure a little, I’ve never seen an employer take a “naughty” line on salary sacrifice e.g. stiffing people on redundancy pay. I’ve also never heard of an employee complain that it’s affected their mortgage offer – most providers are focused on net take home pay these days anyway, rather than headline salary.