What is Salary Sacrifice?

It’s a bit alarming that millions of people aren’t saving enough to fund the lifestyle they dream of in retirement. Even more concerning, many of us haven’t saved enough to cover basic living expenses, let alone the fun stuff. In the UK, many people think the state pension will carry them through their golden years. While it's a helpful boost, the full state pension of £221.20 per week, or £11,502.40 a year, isn’t going to cut it for even a modestly comfortable retirement on its own.

The government knows this, and as the UK population ages, more retirees are leaning on the state instead of their own savings. To tackle this issue, they’ve rolled out several incentives to steer taxpayers in the right direction.

For more details on the State Pension and a taxpayers entitlement, see our video the subject here.

What is Auto Enrolment?

Thanks to the introduction of auto-enrolment in the UK, which makes enrolling in a workplace pension mandatory, private sector pension membership has shot up dramatically. A study showed that right after auto-enrolment kicked in, private sector pension membership jumped from just over 30% to more than 70%—a massive leap in both membership and the funds held in pensions.

How much is going into a workplace pension?

Auto-enrolment means we’re putting at least 8% of our salaries into workplace pensions. Employers contribute 3% of your pay into a pension, and 5% comes from your own paycheck. Some generous employers will even match employees’ contributions, doubling the input up to certain limits.

Even with these minimum contributions, many will find they aren’t saving enough to retire comfortably. There are various reasons for this, like low overall pension savings with little time left before retirement or having a lower income, where 8% of a small salary falls short.

That’s why savvy investors are making additional contributions to their pensions, enjoying tax-free growth and squirreling away more for their future. To sweeten the deal, the government offers tax relief on personal contributions. Personal pension contributions are ‘grossed up,’ adding an extra 20% at source. Higher and additional rate taxpayers can claim an extra 20% or 25% through self-assessment.

What is Salary Sacrifice?

Another way to beef up your retirement savings is through salary sacrifice, also known as ‘salary exchange.’ Employers offering this scheme let employees trade part of their salary for higher pension contributions. This arrangement saves tax for both employer and employee, enhancing the amount paid into your pension plan.

Here's how it works:

First, let’s look at the standard setup under auto-enrolment before diving into salary sacrifice. An employee gets their regular salary with a minimum of 5% deducted for personal pension contributions. This is the ‘net pay arrangement,’ where the personal contribution part of auto-enrolment goes into a pension before income tax is deducted. The employer also chips in a minimum of 3%.

With salary sacrifice, the employee cuts their salary by the personal pension contribution amount. This sacrificed amount is then added to the employee’s pension as an employer contribution.

Both employee and employer national insurance contributions are based on the salary paid, regardless of the employee pension contribution amount. For earnings over certain thresholds, the main rate of Class 1 national insurance for employees is 8%, dropping to 2% depending on income. Employee national insurance savings are added to the employer contributions, bolstering the pension pot.

Employers also save on national insurance they would otherwise pay on the sacrificed amount. Some lucky employees might even get their employers to pass these savings back to them, 13.8% over threshold amounts, further increasing their pension contributions.

Salary sacrifice can lead to significant savings, especially for those whose income edges into the higher or additional rate income tax brackets. Since income tax is calculated on your gross salary, if your salary tips you into a higher tax rate, you can sacrifice the amount within the higher rate bracket to save up to 20% on income tax.

Salary Sacrifice in practice:

Let’s work through an example together:

Ruby earns £40,000 a year. Her employers offer her the option to sacrifice her salary to boost her pension contributions. Being a generous bunch, they’ll pass their National Insurance savings to her as well. Under auto-enrolment, she currently contributes 5%, and her employer adds 3%, the statutory minimums. She wants to know how much she’ll benefit if she sacrifices her salary without reducing her net pay.

First, on a gross salary of £40,000, Ruby makes £2,000 in personal pension contributions per year. She pays £5,086 in income tax and £2,194.40 in national insurance contributions, leaving her with a net pay of £30,719.60. If Ruby sacrifices £2,222.23 of her annual salary, bringing her gross salary to £37,777.77, she’ll pay lower income tax and national insurance—£5,041.55 and £2,016.62 respectively. Her net pay remains the same at £30,719.60 since she won’t make any personal pension contributions.

Before salary sacrifice, Ruby’s employer pays £4,264.20 in national insurance and £1,200 in pension contributions, totaling £45,464.20. Under salary sacrifice, they’ll pay less national insurance (£3,957.53) but will increase Ruby’s pension contribution to £3,728.89. Since they’ve agreed to pass their national insurance savings to Ruby, the employer’s total cost remains the same.

Currently, Ruby’s total pension contributions are £3,200 a year (£2,000 from her and £1,200 from her employer). If she opts for salary sacrifice, she won’t make any personal contributions, but her employer will add £3,728.89 to her pension.

By choosing salary sacrifice, Ruby saves £177.78 in personal national insurance, which is added to her pension. She also saves £44.45 in income tax, and her pension contribution increases by £528.89, for a total saving of £751.12. Ruby’s take-home pay stays the same.

Should Salary Sacrifice be accepted?

This seems like a no-brainer but there are one or two things to bear in mind before accepting salary sacrifice. In the UK, you’re unable to access your pensions until you’re at least 55 years old, soon to increase to 57. If you’re a younger investor, this can be a long time to tie up your money. Additionally, if you’re looking to borrow money, say for the purpose of a mortgage, lenders will use your salary as a basis of affordability. By sacrificing your salary, you may not be able to borrow as much.

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No financial decisions should be taken based on the content of this website or associated videos. The guidance contained within this website is subject to the UK regulatory regime and is therefore primarily aimed at viewers in the UK. Always take full individual advice first. Regulations and legislation governing taxation, investments and pensions may change in the future.

The content on this page is accurate as of the 2024-25 tax year.