Salary Sacrifice How Does it Work? A guide to Salary Exchange

Salary sacrifice is a government endorsed scheme that gives employees the opportunity to improve their take home pay or retirement savings.

At its core, salary sacrifice involves an agreement between an employee and their employer, wherein the former voluntarily relinquishes a portion of their pre-tax salary in exchange for non cash benefits.

A salary sacrifice agreement is sometimes called salary exchange effectively lowers the employee’s taxable income, resulting in a reduced tax bill and an increased net take home pay.

Employers typically provide company benefits focused on childcare, enhanced pension contributions, and transportation mainly through car leasing and the cycle to work scheme.

One of main benefits of a salary sacrifice scheme is that it can make it easier for employees to afford expensive items like cars or bicycles by enabling them to distribute the cost over time.

The perks offered through salary sacrifice schemes are optional, allowing employees paid through PAYE the flexibility to choose whether to participate.

A salary sacrifice scheme is only available to employees through their employers and not to individuals who are self employed.

What are the different types of salary sacrifice scheme?

Currently the four most common salary sacrifice schemes are based on workplace pension contributions, electric car leasing, childcare costs and cycling to work.

Salary exchange schemes not only benefit employees but also provide incentives for employers.

By reducing their employees’ taxable income by giving them some tax free, employers no longer have to contribute national insurance on the sacrificed portion, resulting in a reduction of their NI liability.

Some employers may choose to reinvest a portion or all of these savings into their employees’ pension pots adding to the longer term benefits.

Salary sacrifice pension contributions

One of the most common uses of the HMRC salary sacrifice scheme revolves around enhancing pension contributions.

By diverting a portion of their pre-tax earnings directly into their workplace pension scheme, employees can capitalise on significant tax savings while simultaneously building their retirement nest egg.

By leveraging salary sacrifice to make the same pension contribution your gross annual salary would be reduced but your take-home pay would actually increase.

The financial impact becomes even more pronounced for those teetering on the brink of a higher tax bracket.

An employee earning around the higher rate tax threshold could shift from the 40% rate to the 20% income tax bracket by sacrificing enough salary to take them under the higher rate threshold.

Car leasing salary exchange

Some employers have car leasing salary sacrifice arrangements, enabling employees to enjoy substantial savings, particularly when opting for electric vehicles (EVs).

Under this scheme, the employer leases the car on behalf of the employee from a leasing company, and the employee contributes a monthly fee by sacrificing a portion of their salary.

Industry estimates suggest that individuals can potentially save between 30% and 60% on the cost of leasing an electric vehicle via a salary sacrifice scheme.

HMRC classes a car leased through a salary sacrifice scheme as a taxable benefit which means the employee must pay benefit in kind (BIK) tax in the same way as any other company car.

If the leased vehicle isn’t an ultra low emission model, such as an electric car, the BIK tax could outweigh the savings on income tax and national insurance contributions.

Salary sacrifice child benefits and childcare assistance

For higher-earning individuals with children, salary sacrifice can prove instrumental in retaining eligibility for child benefits and accessing valuable childcare support.

From April 6th, 2023, the threshold for the high income child benefit charge has been raised to £60,000, with complete clawback occurring at £80,000 or above.

By strategically reducing their taxable income through pension contributions via salary sacrifice, higher earners can potentially retain a portion or the entirety of their child benefit entitlement.

The government’s free childcare scheme imposes a strict eligibility cutoff at £100,000 in earnings.

Contributing more to a pension through salary sacrifice could result in higher net earnings for those hovering above this threshold, granting them access to free childcare hours and tax free childcare benefits.

Salary sacrifice cycle to work scheme

The cycle-to-work scheme is a well established salary exchange initiative spanning over two decades and has empowered more than 1 million individuals to buy a bike at discounted rates.

Similar to car leasing, employees contribute a monthly fee by sacrificing a portion of their earnings, resulting in average savings ranging from 23% to 39% on the cost of a bicycle.

The cycle to work scheme’s scope has expanded to encompass other options, including e-bikes, accessories like child seats, and bikes with trailers.

How do I join a salary sacrifice scheme?

Employees must engage in a formal agreement with their employer, specifying the amount they wish to exchange from their salary and the duration of the arrangement.

It is crucial to ensure that the sacrificed sum never dips below the national minimum wage (NMW) threshold which usually goes up each tax year.

If your employer does not currently offer a salary exchange scheme you could initiate a dialogue with the human resources department, union representatives, or staff advocates, highlighting the potential benefits and encouraging them to explore implementation.

Does salary sacrifice show on a payslip?

Yes, a salary sacrifice should be displayed on an employee’s payslip.

The amount sacrificed will be listed as a deduction taken before tax and class 1 national insurance contributions are calculated.

Can salary exchange be applied retrospectively?

No, a salary sacrifice scheme cannot be backdated.

It is only effective from the time an employer and an employee agree upon it, which is when their contract is signed by both parties.

Salary sacrifice considerations

For some savvy employees salary exchange can present some meaningful opportunities to optimise their finances by reducing tax liabilities, bolstering retirement savings, and potentially increasing take home pay.

But while salary sacrifice can present some financial advantages, it is crucial to be mindful of potential drawbacks.

• A reduced salary, as reflected on payslips and bank statements, may impact an individual’s ability to secure borrowing or credit agreements, as lenders typically assess affordability based on reported income.

This is particularly important when applying for finance for example a mortgage when purchasing a home.

Pension contributions are often viewed as discretionary expenses and may not be factored into lending decisions, whereas commitments like car leases would likely be considered.

• Furthermore, certain workplace and statutory benefits, such as maternity pay, life cover, and universal credit, are pegged to an individual’s salary.

Consequently, reducing earnings through salary sacrifice could inadvertently lead to a reduction in certain benefits.

It is essential to thoroughly research and understand the implications of salary sacrifice based on your own personal circumstances, as well as the options for early termination of the agreement.