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Pumping up pensions

The headline-grabbing story from the Budget was the hike in National Insurance contributions. For the pension industry, this means an increased interest in salary sacrifice, the salary planning tool used to offset the effect of tax and NI for both employer and employee.

The premise is simple. The employee opts to give up part of his salary (or bonus) and instead asks for it to be paid as an employer pension contribution. The benefits are that the employer can reduce his NIC bill (as no NIC is paid on employer pension contributions) and the employee receives a welcome boost to his pension planning.

For example, Mr Smith, a higher-rate taxpayer, is due to receive a bonus of £10,000 in August 2003. The whole of the bonus will be taxed at 40 per cent, which, when adding in the deductions for employee NICs, means a take-home pay of just £5,900.

Instead, Mr Smith negotiates with his employer to pay the bonus as an additional employer contribution. His employer saves £1,280 of additional NI contributions and Mr Smith receives an extra pension contribution which, if left invested for 25 years, could buy an additional pension of just under £3,900 at age 65.

Sounds easy enough. And you can see why the increase to NICs in 2003 puts salary sacrifice back on the agenda. But the details of actually setting up a salary or bonus sacrifice in practice are important.

The first step is to set up an informal discussion between employer and employee to start talking about the idea of salary sacrifice. Obviously the closer the employee is to the employer, the easier it will be to do this. A company director will have more success in changing the make-up of his or her remuneration package than a shop-floor worker.

If the decision is made to go ahead, the employer or the adviser should then check with the local Inspector of Taxes for their particular requirements regarding salary sacrifice as these may differ from tax office to tax office. If the proposed sacrifice is more than £5,000, then the tax inspector needs to be informed.

The negotiation then moves on to a more formal basis. A letter should be drawn up, signed by the employer and employee, referring to the sacrifice in salary or in a contractual bonus (no letter is needed to sacrifice a discretionary bonus).

However, the letter should not make any reference to the pension contribution being paid to avoid any implication that the employer may be obliged to make such a contribution. If appropriate, the employer should also send the tax inspector a copy of the letter and ask for confirmation that the arrangement is suitable.

An important aspect is the timing. All this must be done before the sacrifice in salary or payment of bonus is actually made. You cannot receive a bonus and then decide later to sacrifice part of it.

Again, only by being very close to the employer and therefore benefiting from advance knowledge can the employee put these arrangements into place before the change in pay takes effect.

So the process for salary sacrifice can be reasonably straightforward as long as these rules are followed. But I would sound a note of warning – think before you sacrifice.

Check that the increased contribution still falls within the limits allowed – either within the maximum funding level for an EPP or below the age-related percentage for a personal pension or stakeholder (if the total contribution is over £3,600). Remember that as the salary has been reduced this could have an effect on limits previously calculated.

However, a smaller salary means lower maximum benefits from an occupational pension scheme, not only on retirement or transfer but also on death or sickness (say, if there is an accompanying PHI contract).

If the object of the salary or bonus sacrifice exercise is to improve pension and other financial planning then a fall in these allowable maximum benefits could prove to be an unwanted side-effect.

Of course there are other implications from using salary sacrifice that have no relation to pension planning. If there is the possibility that the employee may take maternity leave or redundancy over the next few years then it should be noted that a lower salary would mean that these benefits would be reduced.

Furthermore, a lower salary will also mean that any future applications for bank loans, hire-purchase agreements and mortgages could need to be scaled down.

It all comes down to affordability. The stark truth is that salary sacrifice should only be entered into if the employee is comfortable enough to take a drop in salary – that means taking a good hard look at possible future events.

Although there are things to watch out for, salary and bonus sacrifice can be a good way for company directors and executives to change the remuneration package to bec-ome more tax-efficient and NI-efficient without increasing the overall hiring costs for the company.

It also offers another practical example of how advisers can look behind the headline changes in our economy or society and find the real opportunities for their clients.

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