Salary sacrifice: how to earn less and save more into your pension

Changing the way that you save for retirement could help limit the damage of next year’s national insurance rise.

Pension experts are anticipating a surge of interest in salary-sacrifice schemes ahead of next April, when the chancellor Rishi Sunak’s 1.25% national insurance increase for employers and employees alike takes effect.

In a salary-sacrifice scheme, you agree to give up part of your salary in return for a different benefit worth the same amount. That might be anything from childcare vouchers to membership of a cycle-to-work scheme, but pension contributions are a popular option.

How salary sacrifice works

Typically, employees make pension contributions out of their wages before they are subject to income tax. This means you will pay national insurance on your earnings at the usual rates. In addition, your employer has to pay employers’ national insurance on your wages. 

The effect of a salary-sacrifice scheme, by contrast, is to reduce your salary, with your employer paying the amount you give up straight into your pension scheme instead. National insurance, for both you and your employer, is then calculated on your reduced wages, resulting in lower bills for both parties.

Salary-sacrifice schemes have grown in popularity in recent years. Employers are especially keen on them because the schemes provide an opportunity to reduce their national insurance costs substantially. Some employers even offer to share these savings with staff, in the form of higher pension contributions.

With national insurance due to rise from 6 April 2022 in order to help fund the NHS and the costs of social care, these benefits will become even more attractive. 

A basic-rate taxpayer on a salary of £30,000 will then pay £332.50 in income tax and national insurance on their final £1,000 of pay; assuming they then want to make a £1,000 pension contribution, £200 of that is covered by income-tax relief, but national insurance of £132.50 will still be payable.

By contrast, in a salary-sacrifice scheme, where the employee simply gives up £1,000 of pay in return for a pension contribution of £1,000, there is no income tax or national insurance to pay on the income forgone. In addition, the employer makes a national insurance saving of £177 under the new tax rates. Effectively, employer and employee share a windfall of £309.50.

Mind the drawbacks 

There are some downsides to salary-sacrifice schemes. In particular, they reduce the value of benefits linked to your salary, such as life insurance cover and maternity and paternity pay. 

There could also be an impact on the size of the mortgage you can secure, since lenders look at salary when making advances. Nevertheless, if your employer offers a salary-sacrifice plan, it will be even more worthwhile considering it now that national insurance rates are rising.

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