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Tech centre - Financial planning bulletin

Salary exchange - contribution options

Jul 11, 2018, 15:25 PM

Summary


Salary exchange occurs when an employee agrees to a reduction in their contractual salary in exchange for a benefit of an equivalent value provided by their employer.  Most forms of salary exchange (also known as salary sacrifice) involve a saving in National Insurance Contributions (NICs) for both the employee and employer. Salary exchange can be used in respect of a number of employee benefits e.g. company cars, childcare vouchers, etc.  In this article, we take a look at exchanging salary for employer contributions into a personal pension scheme i.e. a pension scheme operating on a relief at source basis.

Facts and analysis


Salary exchange can be used in a number of ways.

If your client is currently making a personal contribution to their pension plan, they may agree to a salary exchange arrangement offered by their employer that will:

  • keep their take-home pay the same and increase the contribution (paid by their employer) to the pension scheme
  • increase their take-home pay, with the pension contribution (paid by their employer) staying constant, or
  • a mixture of the two, where both the pension contribution and take-home pay are increased (although to a lesser extent than in the previous two scenarios)

Further savings for your client may be available if the employer agrees to forego part or all of their NIC savings and add these savings to their increased pension contribution.
Where there is no existing employee pension contribution, your client could still consider exchanging part of their salary in order to benefit from an increase in their employer’s pension contribution.

How does salary exchange work?

All of the following examples relate to the rates/thresholds applicable to the 2018/19 tax year. 

Example

Mark’s salary is £30,000 pa. He is currently making an employee pension contribution of 5%, i.e. £1,500 (gross) each year. Mark currently pays tax of £3,630 (although £300 of this tax will be added to his net pension contribution (£1,200) so in reality his tax bill is £3,330). He pays NICs of £2,589.12 and a net pension contribution of £1,200. Mark’s take-home pay is £22,580.88.

With Salary Exchange

  • Option 1 – to keep take-home pay the same and maximise pension contributions

    Mark agrees to exchange £1,764.71 of his salary for an employer pension contribution of the same amount.

    On a reduced salary of £28,235.29

    Tax = £3,277.06

      NICs = £2,377.35
      Take-home pay = £22,580.88
      Outcome - take-home pay is identical, yet the pension contribution has increased from a £1,500 employee contribution to a £1,764.71 employer contribution.

      Also, the employer’s NIC bill will reduce by 13.8% of the amount of salary sacrificed. This is because employer NICs are payable on salary over the Secondary Threshold but not on employer pension contributions.

      So, if the employer is willing to forego their NIC saving (13.8% of £1,764.71 = £243.53), they may add this to the employer pension contribution, increasing it to £2,008.24.

      Potentially, the pension contribution has increased from a gross employee contribution of £1,500 to an employer contribution of £2,008.24, yet Mark has the same take-home pay, and the employer is no worse off.
  • Option 2 – to keep the pension contribution the same and maximise take-home pay
    • a. Assuming that the employer retains all of their NIC saving, this is simply a case of Mark sacrificing an amount of salary equal to his gross employee contribution, i.e. £1,500.
      Mark gives up £1,500 salary and his employer makes a contribution of £1,500, so there is no change as far as the pension contribution is concerned. However, take-home pay increases.

      On a reduced salary of £28,500:

      Tax = £3,330.00

      NICs = £2,409.12 

      Take-home pay = £22,760.88

    • b. If the employer is willing to forego all of their NIC savings, the situation improves further for Mark. In this scenario, a lower amount of £1,318.10 salary is exchanged.

      When the employer’s NIC saving of £181.90 is added this results in an employer contribution of £1,500.

      On a reduced salary of £28,681.90:

      Tax = £3,366.38

      NICs = £2,430.95

      Take-home pay = £22,884.57

  • Option 3 – a compromise, i.e. increases to both pension and take-home pay
    For instance, assuming that the employer retains their NIC saving, Mark might agree to exchange £1,600 of his salary.

    On a reduced salary of £28,400:

    Tax = £3,310.00

    NICs = £2,397.12

    Take-home pay = £22,692.88

    In comparison to the pre-exchange situation, the pension contribution has increased from £1,500 to £1,600, and Mark’s take-home pay has increased from £22,580.88 to £22,692.88.

Calculating the amount of salary to exchange

  • Option 1 – to keep take-home pay the same and maximise pension contributions

    It is often possible to apply a simple method to calculate the salary exchange figure, but only where the individual is in the same tax/NICs band both before and after salary exchange.
    If they cross a threshold (e.g. salary drops from £47,000 to £43,000 as part of salary exchange), the following method will not work.
    Additionally, the loss of the personal allowance (£1 for every £2 in excess of £100,000) also complicates matters, and again the calculations below will not work where income falls between £100,000 and £123,700 either before or after salary exchange.

    Method

    Employee pension contribution (net of all tax relief) divided by:

    1 – [(rate of tax*/100) + (rate of NI*/100)]

    These are the highest rates that the individual is subject to, i.e.

    • 20% and 12% respectively for someone with earnings around £30,000, and
    • 40% and 2% for someone with earnings around £60,000, and so on.
    Example 1

    In Option 1 above, the salary exchange figure of £1,764.71 can be calculated as:

    £ (1,500.00 x 0.80) divided by 1 – [(20/100) + (12/100)]

    i.e. £1,200/0.68 = £1,764.71

    Example 2

    For someone earning £60,000, currently making a personal contribution of £3,000 (gross), the amount of salary to exchange that keeps take-home pay the same can be calculated as:

    £ (3,000.00 x 0.60) divided by 1 – [(40/100) + (2/100)]

    i.e. £1,800/0.58 = £3,103.45

    Important notes
    • Whether or not the employer is adding some or all of their NIC saving to the employer contribution does not affect the amount of salary that needs to be exchanged.
    • Calculations and examples have been based on 2018/19 tax rates, bands etc.
    • Calculations based on your clients’ personal circumstances will differ.
  • Option 2 – to keep the pension contribution the same and maximise take-home pay


    Where the employer keeps all of their NIC saving - the individual needs to exchange an amount of salary equal to the gross amount of the employee contribution they are currently paying. This is shown in Option 2a) above.

    Where the employer adds in some or all of their NIC saving – the individual needs to discount the amount of salary to exchange by the amount of the employer NIC saving that is to be added.

    In option 2b) above:

    The employer was willing to add in all of their NIC saving,

    • the (gross) employee contribution of £1,500.00 could be discounted by the employer’s 13.8% saving on the reduced amount i.e. (1,500/1.138) = £1,318.10
    • the employee gives up £1,318.10 which reduces the employer’s NIC bill by £181.90
    • the employer adds their saving to the salary that’s been exchanged, giving an employer contribution of £1,500.
    Clearly, the employee is better off in 2b) as they’ve been able to maintain their pension contribution level with a lower amount of salary being sacrificed.
  • Option 3 – a compromise
    This option may involve a combination of the above with adjustments to both take-home pay and pension contributions, based on the individual’s specific requirements.

Further information on Salary Exchange

  • Take a look at the Salary Exchange site on Aviva for Advisers where you can find literature which expands on some of the points we have mentioned in this article - we have also included a number of examples, and access to our Salary Exchange Calculators
  • HMRC have provided detailed guidance around the contractual issues of salary exchange, examples of effective and ineffective exchanges etc. on their website.
    The HMRC guidance includes:
    • an overview of salary sacrifice, HMRC’s role and the impact salary sacrifice may have on other benefits, and
    • a series of questions and answers for employers and individuals considering a salary sacrifice arrangement

Impact on other benefits

It is not all good news - as a salary exchange arrangement means your client will be agreeing to a reduced salary, this can impact on their entitlement to certain benefits.

  • For instance, a reduced salary may lead to reduced State benefits (although it may lead to an increase in some benefits, such as Working/Child Tax Credits).
  • This is an area we have not covered in this article and, if this is likely to be an issue for your client, we would recommend that they refer to their local Benefit Office for guidance.
  • Also, a reduced salary may have an impact elsewhere e.g.- mortgage applications may have to be based on the reduced salary, and if overtime or bonus is based on basic salary, a reduction due to salary exchange could lead to lower payments.There again, your client’s employer (or mortgage provider) may be happy to base these items on a notional, pre-exchange salary.

Points to consider

It’s important to remember that salary exchange is generally a matter of employment law (as it involves a variation to your client’s contract of employment). Although HMRC provide some guidance on their website, ‘pension legislation’ does not cover this subject.

  • The salary exchange ‘agreement’
    Any salary exchange arrangement should be formally documented, normally in a written agreement between the employee and employer.

    Any exchange should be entered into for a period of at least 12 months. If your client reverts to their original salary within 12 months HMRC may deem the salary exchange to be ineffective.

    However, there are certain “lifestyle events” that may allow your client to revert to their original salary within 12 months (e.g. redundancy of a partner).
  • Annual Allowance
    Where pension contributions resulting from salary exchange approach or exceed your client's annual allowance, it’s always worth pointing out to your client that the annual allowance implications may need to be considered.

    It may be perfectly OK to make contributions in excess of their annual allowance– your client may have sufficient carry forward of unused annual allowance to cover the excess.
  • National Minimum Wage
    Your client will not be able to exchange so much of their salary that it falls below the national minimum wage.

    For instance, if your client was looking to exchange all of their salary, this would not be acceptable to HMRC.

    Details of the current rates of national minimum wage are available on the Direct.gov website:

Rates and thresholds for 2018/19

Tax
Rate
£
Personal allowance
0%
£11,850
Basic rate band
20%
£34,500
i.e: higher rate threshold £46,350
Higher rate band
40%
£115,500
i.e: additional rate threshold £150,000
Additional rate
45%
> £150,000

*The above figures do not apply to Scottish taxpayers.. 


National Insurance
£
Secondary Threshold (ST)
(point at which the employer pays NICs)
£ 8,424
Primary Threshold (PT)
(point at which the employee pays NICs)
£ 8,424
Upper Earnings Limit (UEL)
(point at which the employee NIC rate reduces)
£ 46,350
Employee pays 12% on earnings between PT & UEL, 2% on earnings over UEL
Employer pays 13.8% on all earnings over ST
  • Personal Allowance
    We have considered the impact salary sacrifice may have on avoiding loss of personal allowance in a separate article: ‘Pensions planning - contributions and preserving the personal allowance’

Next steps

The points to consider will vary, depending on whether your client is an employer or employee.

  • Employer Does your client already provide a salary exchange arrangement for members of their pension scheme?
    • If not, is this an extra benefit they may wish to offer to their employees?
    • The employer will need to consider the extent of any new arrangement, and whether they would also direct any NI savings into their employee’s plans as an additional benefit.
  • Employee Do you have any clients who are already participating in a salary exchange arrangement?
    • Do they need to review the amount exchanged? However, care should be taken as a renewal to an existing salary exchange agreement would be seen as a new salary exchange agreement for the purposes of calculating 'threshold income' in the context of the tapered annual allowance.

Learning outcomes and reflective questions for CII accredited CPD


Reading this article can count towards structured CPD under the CII CPD Scheme if you consider the Learning Objectives below to be directly relevant to your own personal professional development plan. The Reflective Questions don’t require answering, they are aimed to help you reflect on the issues raised in the article for your reflective statement on your CPD Certificate.

Learning objectives:

  • To understand the various ways in which salary exchange can be used – to benefit pay, or pension contributions.
  • To be aware of the issues that mean salary exchange may not be suitable.

Reflective questions:

  • How can salary exchange be used to reduce a client’s adjusted net income, to reinstate their personal allowance, or mitigate the affect of the child benefit tax charge?  
  • Will the client’s employer forego some or all of their NIC saving?


Important information


The information contained in this article has not been approved for use with customers and is based on Aviva's interpretation of current law and legislation and our understanding of HM Revenue & Customs (HMRC) practice as at 6 April 2018. It is provided for general information purposes only and should not be relied upon in place of legal or other professional advice. Both the law and HMRC practice will change from time to time and our interpretation may be subject to challenge by the HMRC or other regulatory body. Aviva cannot act as legal advisor for you or your clients. You should always seek appropriate legal or other professional advice. (Ref 1.18)

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