Archived article: Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Reports suggest reform of salary sacrifice pension schemes could be on the cards as the Chancellor chooses to dance around Labour’s manifesto promises to boost the public finances.
Although clamping down on salary sacrifice isn’t an explicit tax rise, many employees will see less in their pay packets and ultimately their pension pots too. And asking businesses to absorb yet another cost might be one step too far, particularly at a time when the number of people out of work is already at its highest rate since the pandemic.
How does salary sacrifice work?
If you’re in a workplace pension scheme, you’ll usually see three main deductions before you get your take home pay – income tax, employee National Insurance (NI), and pension contributions. The same overall amount still goes into your pension but, depending on what type of scheme you’re in, your pension contributions may come out first, second, or third.
Although your contributions are free from income tax, both methods mean they are taken from pay after your NI contributions have been deducted. But salary sacrifice arrangements let you make your own pension payment before interference from both NI and income tax. You can make a formal agreement with your employer to give up a portion of your salary in return for a certain benefit, in this case a pension contribution. The main benefit to you is the employee NI saving, up to 8% depending on your earnings, does not eat into your contributions. But these agreements do involve a cut on paper to pay, which could be important when it comes to things like being approved for a mortgage.
The savings on offer are even larger for employers, with employer NI of 15% saved on the amount of pay that is sacrificed. Some workplaces reward employees by sharing all or some of this saving towards boosting what they pay into your pension even further. A cap will lead to many employers reviewing benefit packages for staff against the payroll and admin costs, and others might stop sharing the savings with their workers entirely, as well as potentially putting the brakes on new hires.
How could a cap impact my pension?
One option on the table is to introduce a £2,000 cap on the amount of earnings that can be exchanged for pension contributions that benefit from a NI exemption. Such a cap could reportedly raise up to £2 billion a year, but it also runs the risk of savers having less in their pension pots when they reach retirement.
Our analysis shows that someone aged 35 earning £50,000 a year could face a hole in their pension of £22,060 by age 65 under these plans. This assumes they already have a pension fund of £30,000 and make an overall contribution of 5% personally, with another 3% coming from their employer. The black hole rises to more than £37,000 or even nearly £50,000 if they are already a higher earner on £75,000 or £100,000 respectively.
Those diligently saving more than the current minimum for a better retirement could see some of their pension contributions subject to NI deductions, including some lower earners.
| Projected pension pot at retirement | |||
|---|---|---|---|
| Current salary | Current system | £2,000 salary sacrifice limit | Difference |
| £40,000 | £478,518 | £458,417 | £20,101 |
| £50,000 | £564,113 | £542,053 | £22,060 |
| £75,000 | £778,098 | £740,897 | £37,201 |
| £100,000 | £992,084 | £942,402 | £49,682 |
Source: AJ Bell. Assumes 5% investment growth after charges, 2% price inflation and 3% annual earnings growth
What about my take home pay?
Let’s consider the example of Sally, who earns £55,000 a year. She wants to make higher personal contributions to her workplace pension of 10% and her employer has offered her salary sacrifice as an option.
Under a salary sacrifice scheme, Sally’s take home pay would be £39,161 a year – an employee NI saving £158 a year higher than she would enjoy if there was no arrangement. Her income tax bill and pension contribution are the same, but her employer would also save £825 a year in employer NI.
A cap on the pay that would be exempt from NI under salary sacrifice would cost Sally £118 in savings a year, with her employer facing £525 in extra employer NI compared to no cap.
| Sally | Current scheme | Cap NI exemptions at £2,000 | No salary sacrifice |
|---|---|---|---|
| Take home pay | £39,161 | £39,043 | £39,003 |
| Employer NI bill | £6,675 | £7,200 | £7,500 |
Source: AJ Bell
Pension contributions are still tax-free
Even if the benefits of salary sacrifice were reduced, people will still be able to get income tax relief on their pension contributions. Rather than making a formal arrangement to keep salary below a certain level, you’ll need to work out what extra contributions you must make to reduce your ‘adjusted net income’. This will involve added time and admin but will still be well worth it when you consider the potential tax savings on offer.
Pension contributions can reduce adjusted net income and help taxpayers out of punishing tax traps while boosting retirement savings.
For example, someone with an adjusted net income of £60,000 or more will start to see any child benefit clawed back and someone breaching the £100,000 limit starts to lose their tax-free personal allowance for the year. In both cases, their extra earnings face an effective tax rate of 62% if you include employee NI. But the cliff edge is astonishing for parents of young children, who lose their entitlement to tax-free childcare and extra funded childcare hours as soon as they tip over the £100,000 cliff edge.
Charlene Young: Senior Pensions and Savings Expert
Charlene Young is AJ Bell’s Senior Pensions and Savings Expert. She joined AJ Bell in 2014 from a wealth management firm where she worked with private clients and small businesses as a financial planner.
Charlene...
