Increase your net income using salary sacrifice

Friday. July 02, 2021 - 5 mins read

Too often, when people are asking what to do with their bonuses, the advice given is to divert some of it (using salary sacrifice) to their pension to make use of the tax-relief. This sounds fully correct at first glance, but on closer examination, can sometimes prove to be less tax efficient.

Pre-requisites

You are employed and have your taxes operated under PAYE with regular monthly salary payments
Your monthly gross salary is above the Upper Earnings Limit (UEL for National Insurance (NI). As of April 2021 this is currently £4189. This is roughly correlated with the higher rate tax threshold
Your employer matches pension contributions holistically or anually rather than monthly
Your employer operates a salary sacrifice scheme
Your employer allows you to change your salary sacrifice contribution over the course of a year

How does this work?

The fact that tax works on an annual holistic basis in the UK is well-known. It doesn’t matter when or how you earn your money, it’s taxed by PAYE in as smooth a manner as possible (hello cumulative tax codes!) but reconciled anually at the end of the tax year based on the holistic income and gains then.

The kicker here is that NI is calculated per pay-period and not reconciled anually. There’s not quite the same thing as “over paying” NI in one month due to a bonus and expecting a rebate at the end of the year or in next months payslip as there is with tax.

Additionally, salary sacrifice works by reducing your salary in exchange for your employer contributing directly to your pension. In HMRC’s eyes, it’s as if you never earnt that money. The timing of this doesn’t make any difference for PAYE because the only figure that matters is your total taxable income at the end of the tax year. It does make a difference for NI, however.

The typical situation

A typical agreement between an employee and employer will have the employee agree to x% salary sacrifice as a pension contribution which is applied to each monthly payslip. As an example, take Bob who earns £96k and salary sacrifices 20% to his pension. His monthly payslip looks like:

Gross: £8,000
Pension contribution (SS): £1,600
Taxable income: £6,400
Tax: £1,512.66
NI: £451.26 ((6400 - 4189) * 2/100 + (4189 - 797) * 12/100)
Net: £4426.08

Had he not made any pension contributions, it would look like:

Gross: £8,000
Pension contribution (SS): £0
Taxable income: £8,000
Tax: £2152.66
NI: £483.26 ((8000 - 4189) * 2/100 + (4189 - 797) * 12/100)
Net: £5364.08

you can see that the salary sacrifice has reduced the tax paid substantially (all at 40%) whereas has barely impacted the amount of NI paid (most of it as 2%). This is because the NI payment drops from 12% to 2% when you cross the upper earning threshold, so you’re getting less relief.

Shuffling things around

Given that tax is paid holistically, we don’t care about the monthly tax position, it’ll sort itself out at the end of the year, but we can concentrate our pension contributions to a single (or as few as possible) month(s) to make sure that we make full use of the 12% NI relief rather than the 2%.

Bob makes a total pension contribution of £19,200. If we split that across three months instead of 12 (we need each monthly payslip to be above the minimum wage for a months full-time work), those three months look like:

Gross: £8000
Pension contribution (SS): £6,400
Taxable income: £1,600
Tax: (doesn’t matter)
NI: £96.36

and the rest of the 9 months look like the situation above where he doesn’t make any pension contributions whatsoever.

The result

In both situations, Bob pays the exact same amount of tax (£18,152) by the end of the year but pays £5415.12 (451.26 * 12) NI by paying it monthly and £4,638.42 (483.26 * 9 + 96.36 * 3) by concentrating the contributions to 3 months.

That means Bob puts the exact same amount of money into his pension at the end of the year, pays the exact same amount of tax, but sees an extra £776.70 show up in his bank account for doing nothing other than pestering his employers HR to follow his ‘convoluted’ pension contribution strategy. This saving comes from exploiting the fact that NI is calculated per pay-period and maximising the relief at 12% from a few months rather than skimming the 2% relief every month.

Caveats

This ignores:

employer contributions which you might be missing out on depending on how your employer calculates their matching (mine is non-contributory, so I don’t miss out on anything there)
A cash-flow crunch, there are 3 months in which you see much less come in from your payslip which you need to conciously cover from the increased monthly payments in other months. You could also price in the time-value of money (though that is very nitpicky)
If you choose to back-load the pension then you miss out on ‘time in the market’ and potential gains, but ensure that you remove the risk of ‘over-contributing to your pension’ early-on and removing flexibility had you been let-go or some emergency come up since pension contributions are irrecoverable
If you choose to front-load the pension, then you gain ‘time in the market’ which is a good thing but lose out on flexibility (say an emergency comes up later in the year where you wish you could then turn your contribution down).

The last 3 points can be mitigated somewhat by spreading Bob’s three months across the tax year, but may not be possible depending on your level of pension contribution and salary (maybe only one month is enough to make your full pension contribution).

Conclusion

If the stars align just right and this works for your situation as it does mine, then this can be a nice chunk of free money for almost no work and I would definitely recommend doing it, though do have a chat with your HR department before to make sure that it’s all kosher for you.

Disclaimer

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