A Salary Sacrifice Pension for Employees
Pension investing always make sense inasmuch as it allows workers to set money aside for retirement while avoiding some taxation during their working years. However, a salary sacrifice pension scheme offers additional benefits that need to be considered. A salary sacrifice pension is an optional form of pension saving that is arranged between employer and employee through the employment contract.
Before we explain how salary sacrifice works in relation to pension savings, we need to first explain the basic principle of salary sacrifice. Needless to say, it can be applied in many different ways – it is not exclusive to pension investing.
HMRC defines salary sacrifice as an "an agreement between an employer and an employee to change the terms of the employment contract to reduce the employee’s entitlement to cash pay. This sacrifice of cash entitlement is usually made in return for some form of non-cash benefit."
Simply put, salary sacrifice is an arrangement whereby you agree to give up some of your take-home pay in exchange for an alternative, non-cash form of compensation. That compensation may be pension contributions, vouchers to pay for childcare expenses or use of a company vehicle.
The Salary Sacrifice Pension
Applying the salary sacrifice rules to a pension can be a little bit difficult to understand. First, you need to know that even though your contributions to a standard pension plan are made with tax-free monies, the government still differentiates contributions under a standard arrangement from a salary sacrifice scheme.
With salary sacrifice, you agree to give up some of your cash compensation in exchange for your employer contributing the same amount to your pension scheme. Why choose this option? Because both you and your employer save money on the deal. You save by reducing your income tax and National Insurance contributions; the employer saves by way of lower National Insurance payments as well.
Let us assume the combination of your personal allowance and annual salary adds up to £45,000 this year. You would be in the 40% tax band. Then let us also assume you could live comfortably on just £35,000 annually. If you are willing to sacrifice £10,000 in salary, you would then fall into the 20% tax band, and you would have the added benefit of automatically contributing the difference to your salary sacrifice pension. You pay no income tax or National Insurance on that £10,000.
Because your employer also saves on National Insurance under this sort of scheme, they might be willing to cover the entire portion of your mandatory contributions as required by auto-enrolment rules. This provides additional funds for your pension without costing the company anything more.
Setting up a Salary Sacrifice Pension
Because salary sacrifice is an agreement to give up some of your salary in exchange for a company-provided benefit, a legal contract must be in place to govern the transaction. Government rules require a new contract every time the status of a salary sacrifice scheme changes. You will be presented with a contract when you first agree to your pension; a new contract will have to be furnished should you decide to opt out or your employer needs to make changes.
Please bear in mind the following:
- Government Restrictions – The government has instituted very strict guidelines regulating how salary sacrifice arrangements can be utilised. These restrictions are in place as a means of preventing employers and their workers from utilising salary sacrifice for the purposes of tax avoidance.
- Salary Sacrifice Total – Regardless of how many salary sacrifice agreements are arranged between employers and their workers, the law does not allow an employer to reduce a worker's cash earnings through salary sacrifice below the National Minimum Wage. In 2015, that means no less than £6.70 per hour for workers over the age of 21.
- Income Tax – Although a salary sacrifice pension scheme may reduce your tax liabilities while you are working, you will still pay income tax on all pension monies when you retire. The advantage of using salary sacrifice now is one of reducing your tax rate. You can then take income in retirement in low enough amounts to keep you at the minimum rate.
Determining If It's Right for You
At first glance, it may seem as if a salary sacrifice pension is the best option for everyone. This is not true. Salary sacrifice does have some inherent disadvantages that could affect your take-home pay and tax credits negatively. You need to assess your circumstances in light of all your options in order to know what puts you in the best financial position.
There are at least four things to think about:
- Life Cover – Employer-sponsored life cover may be tied to your take-home pay in terms of how much cover you receive. It is important to find out from your employer whether a salary sacrifice plan would affect your life cover in any way.
- Borrowing – When you apply for a mortgage or any other form of credit, the lender will take into account your salary when rendering a decision. A lower salary could make it harder to borrow.
- Public Benefits – You may be entitled to certain public benefits depending on your current financial circumstances. However, those benefits could be lost if salary sacrifice results in your salary falling below the level required for National Insurance payments.
- Contribution Refunds – Some occupational pension schemes offer contribution refunds to workers to leave employment within the first two years of participation. In the case of a salary sacrifice pension, no refunds will be given because no contributions were made.
These inherent weaknesses do not automatically prevent you from using salary sacrifice if you are on the lower end of the earning scale. Nevertheless, you do have to be more cautious not to trade one benefit for another while risking being worse off for it. It is always important to consider both your current circumstances and your long-term retirement goals when making any decision about your pension savings.
Employer Responsibilities for Salary Sacrifice
Should you and your employer agree to establish a salary sacrifice pension, the law requires certain things of your employer. Most importantly, the employer will have to report all non-cash benefits to HMRC at the end of the tax year. That means the government will know what your arrangements are from year-to-year.
Second, your employer is required to check with HMRC to verify the salary sacrifice plans fall within the acceptable guidelines. HMRC will provide clear guidance on tax and NIC implications at the request of the employer.
Lastly, your employer must give you the opportunity to opt out of the salary sacrifice scheme at any time. You cannot be forced by your employer to accept less salary than your original contract called for. The entire programme is voluntary on both sides.
A salary sacrifice pension scheme is a tax-efficient way to save for retirement. You save on income taxes, and both you and your employer save on National Insurance contributions. The result is guaranteed money put into your pension pot where it can grow over time. Sacrificing some of your salary now could result in you having quite a bit more than you expected at retirement. There is certainly nothing wrong with that.
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