The benefit is that employer contributions do not attract National Insurance contributions while those paid by employees come from income on which NI has already been paid. With employer NICs sitting at 12.8 per cent of earnings above £110 a week and employee NICs at 11 per cent of earnings between £110 and £844 a week and 1 per cent on higher earnings, the saving can be substantial.
Salary sacrifice is a perfectly legitimate way to save NICs, and HM Revenue & Customs even publishes guidelines to help employers get it right.
The main considerations are it must represent a genuine variation in the contract of employment and must be agreed before the earnings become due. It is possible to set up an arrangement where salary is automatically sacrificed unless the employee chooses otherwise. Such arrangements are often known as smart schemes.
The question then arises of what is to be done with the NICs saved. There are three possibilities. They could be used to increase the employee’s take-home pay, reduce the employer’s costs or increase overall pension contribution.
In practice, more than one of these may apply but it is important that the basis used is clearly understood.
The most straightforward sacrifice is to reduce the employee’s salary by the amount of the gross pension contribution. If the employee pays, say, £200 a month net into a personal pension, the reduction to yearly salary is 200 / 0.8 x 12 = £3,000. Since the employee will automatically pay lower NICs, net income over the year will then increase by £330 (11 per cent of £3,000) or by £30 (1 per cent of £3,000) depending on the rate of NICs on the top slice of earnings.
If the employee is a higher-rate taxpayer, there may be a greater increase in immediate take-home pay as the difference between basic rate and higher-rate relief is claimed in the self-assessment tax return but once all tax for the year has been finalised the difference is only the NIC saving.
In this case, the employer saves NICs of 12.8 per cent of £3,000, which is £384. This can be used to increase the total pension contribution or to reduce the employer’s costs. Some employers choose to pass part of the saving on and retain the rest.
A more sophisticated form of salary sacrifice aims to leave the employee’s net income unchanged and apply the whole NIC saving to the pension. In this case, the reduction to salary is greater than the original gross contribution because the NIC saving goes towards net income.
The employer saving – both salary and NICs – is higher than in the more straightforward version, and so the amount that can be added to the pension is also higher.
This approach to the sacrifice is less intuitive but can result in a significantly higher pension contribution. In the example above, for someone paying NICs at 11 per cent on the top slice of earnings, the yearly increase to pension could be £923.48. The straightforward version increased pension income by £384 and added £330 to net income.
On the surface, salary sacrifice looks simple, but there are a number of variations like this that could benefit clients. It is worth investing some time in ensuring you understand them.
Ian Naismith is head of pensions market development at Scottish Widows