Should you sacrifice your salary for a bigger pension?

Salary sacrifice can be one of the most effective means of boosting your personal wealth, and it could be worth seriously considering especially if you’re wondering how to spend your annual bonus.

The thing that makes salary sacrifice such a powerful savings tool is that it reduces the amount of income tax you pay on your earnings, meaning you get more bang for your buck. Salary sacrifice is most often used to increase pension contributions, but it can be used for a variety of benefits.

“Many employers offer salary exchange which is also known as salary sacrifice,” says Clare Moffat, pensions and tax expert at Royal London. “It’s where you agree to exchange part of your salary and then your employer pays all of the pension contribution instead of you paying some and them paying some.”

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Salary sacrifice makes sense for employers, as it enables them to offer greater perks to their employees without increasing their salaries, which many are reluctant to do at present given the government’s increase in employers’ National Insurance contributions (NICs).

“Following the Chancellor’s decision to raise employer contributions to National Insurance, the attraction of salary sacrifice has grown markedly,” says Lisa Caplan, financial planner at Charles Stanley.

Research from Charles Stanley Direct shows that 30% of DIY investors would opt in to a salary sacrifice scheme in order to boost their savings. Of these, a fifth say their employer already offers a scheme that they don’t currently use, but plan to. A further 10% say their employer doesn’t currently offer salary sacrifice, but they would opt in if it did.

But what is salary sacrifice, and how can you use it to boost your pension savings and gain access to other perks?

What is salary sacrifice?

Salary sacrifice is an agreement to reduce your cash pay, usually in return for a non-cash benefit. That could include pension contributions, medical insurance or even a car.

“Using salary exchange is a way for more money to go into your pension but without any extra cost,” says Moffatt.

“The benefit is that you pay less income tax and National Insurance. That’s because your salary is reduced before tax and National Insurance is taken off. Your employer also pays less employers’ National Insurance, and they might pass on some or all of this saving to you.”

Higher or additional rate taxpayers who are in a group personal pension get an additional benefit, as they receive all the tax relief rather than having to claim anything above basic rate back from HMRC.

“Many higher and additional rate taxpayers with group personal pensions forget that they have to claim their tax relief back and are losing out,” says Moffatt.

Moffatt gives a hypothetical example of Maria, who earns £35,000 and lives in England during the 2024/25 tax year. Maria’s employer returns 50% of the National Insurance savings to employees.

“She pays tax, National Insurance and an employee pension contribution of £1,400 and her employer pays £1,050 into her pension. This means Maria has a take home salary of £27,320. If she chooses salary exchange, it means her salary is lower, just under £33,056. She makes no pension contribution and that’s because her employer makes it all on her behalf.

“Maria’s take home salary is still £27,320. But the tax and National Insurance saving means that there is now £3,129 going into her pension instead of £2,450. Even if Maria’s employer didn’t pay some of their National Insurance saving in, it would still mean a reduction in tax and National Insurance for Maria.”

Workers could boost their pension pots by £41,200 – more than a year’s average salary – by opting into their employers' salary exchange scheme, according to new figures from Scottish Widows.

Average salary workers – taking home £37,4301 annually – could increase their take home pay by £150 a year, simply by opting into their employers' salary exchange scheme. If this extra cash is then redirected into their pension pot, alongside the savings the employer makes through reduced national insurance contributions, their pension savings would be boosted by £528 a year.

For a worker aged 30 and retiring at age 67, and assuming 5% investment growth, this would add £41,200 to their pension savings. Those opting in a decade later, at age 40, would see a £24,500 boost to their pension pot.

With the future of salary exchange under the spotlight following recent HMRC research, the calculations emphasise the positive boost these schemes have on workers' financial empowerment.

Among the workers enrolled in salary exchange who were surveyed by Scottish Widows, 79% said it makes them feel more confident about maximising their pension savings and being tax efficient when managing their money (77%).

Is salary sacrifice just for your pension?

Most people tend to associate salary sacrifice with pension contributions, but it can be applied to a wide range of other benefits.

For example, there are salary sacrifice electric car schemes, where employees sacrifice some pre-tax salary in exchange for the monthly lease on an electric vehicle (EV). These enable employers to lease EVs from manufacturers, and for employees to then lease these from the employer, with the same tax advantages that pension salary sacrifice offers.

Other salary sacrifice schemes include cycle to work schemes, workplace nursery schemes, which offer help with the cost of childcare, or technology schemes that could help spread the cost of a new phone or laptop.

Can you use salary sacrifice on your bonus?

If you’ve recently been paid a bonus, you may be wondering what the best way to spend it is. Some employers offer a bonus exchange scheme, which has similar benefits to salary exchange – with the perk of not reducing your monthly income.

“The key things to consider are immediate financial priorities like debt which you may want to pay off immediately,” Susan Hope, retirement expert at Scottish Widows, tells MoneyWeek.

“Secondly, when you might need this cash, for example savings for an emergency or savings goals in the medium-term.

“If it’s money that you don’t need for any of those types of things, using salary exchange to put it into your pension could help not only boost your pot, but for higher earners it could also help when it comes to tax, childcare benefit and personal allowance.”

For a basic rate taxpayer, paying directly into a pension using salary exchange could change a £5,000 bonus into a £6,090 pension contribution in the 2024/25 tax year, or a £6,150 contribution from 2025/26, once the reductions in employer and employee NICs are taken into account.