According to Section 62 ITEPA 2003, salary sacrifice occurs when the employee relinquishes the right to receive a portion of cash compensation owed under the employment agreement. The salary sacrifice is often made in return for the employer’s willingness to provide non-cash benefits. The employer agrees to vary the employee’s ‘terms and conditions’ of employment as these relate to compensation or remuneration. If the employee’s current employment agreement states he receives £40,000 per year (without benefits). The employee negotiates that, in lieu of £5,200 in cash compensation, he will receive childcare vouchers over the year (e.g. 52 vouchers valued at £100 apiece). This exchange is referred to as salary sacrifice under the law. Employees may sacrifice other cash payments from a employer, such as a bonus payment.
Salary sacrifice benefits
Walter Sinclair and E. Barry Lipkin (“St. James’s Place Tax Guide 2012-2013,” 2012) write that salary sacrifice, also called salary exchange, is not the same as other ‘net pay arrangement’ schemes. Salary sacrifice occurs “where salary is reduced in order to boost employer contributions and avoid a liability to National Insurance (because pay is never received as such). Employers may elect whether they wish to operate a relief at source or net pay arrangement for all members.”
According to author Nick Braun, (“Retire Rich With a Self Sacrifice Pension,” 2012)salary sacrifice can help employees increase their pensions by as much as £50,000 whilst saving on taxes and national insurance. Braun recommends structuring a ‘salary sacrifice pension’ can help people live better in retirement.
EIM42780 (Salary sacrifice: contributions to a registered pension scheme: income tax effects, Sections 62 and 308 ITEPA 2003) explains the impact of income tax effects in exchange for an employer’s payment of a certain sum into a registered pension scheme for an employee’s financial benefit. According to law, “potential future cash remuneration is not taxable; the pension contribution made by the employer in return for the sacrifice will be an employer’s contribution.
Successful salary sacrifice
A non-director level, senior employee receives an annual cash bonus. The amount of bonus received is calculated on the employer’s annual profitability. (Therefore, the bonus received is not guaranteed annual compensation.) The employee is advised that the annual bonus payment is £10,000 in a letter. The employee learns he may choose between receipt of the cash bonus or ask the employer to contribute the bonus to a registered pension scheme for the employee’s financial benefit. By agreeing to contribute the bonus to the pension scheme, the employee completes a written authorization. In doing so, he gives up the right to change his mind about receiving cash proceeds of the awarded bonus amount.
According to EIM42760, the sacrifice is considered successful because of proper timing. The bonus would have been booked as taxable money earnings if not contributed to the registered pension scheme. The revised ‘terms and conditions’ of the employer and employee demonstrates that the employee received lesser taxable cash compensation as well as a non-taxable benefit in the pension. Therefore, the £10,000 is not taxable.
Unsuccessful salary sacrifice
EIM42786 demonstrates how salary sacrifice attempts can go awry. An employer maintains a registered pension scheme for a business employing 20 persons. An insurance company manages the scheme. Every employee may opt to join the pension scheme (and determine the amount of salary to be committed towards a monthly pension contribution). The employee agrees to send a personal cheque or arrange for automatic bank withdrawal of funds by the insurance firm. The employer collects all employee contributions participating in the scheme and sends a single cheque for the aggregate employee contributions to the insurer. Alternatively, the employer may agree to automatically withdraw funds from employees’ monthly pay. The employees agree to allow the employer to automatically deduct pension scheme contributions from the wage packet.
This is an example of an unsuccessful salary sacrifice. Unfortunately, the necessary revision of compensation terms and conditions does not occur here. Each employee is still entitled to cash compensation levels as before. The employee asks the employer to automatically debit a portion of cash remuneration on behalf, in order to make the employee’s pension contribution. Each employee participating in the scheme is taxed on the continued level of cash compensation. Of course, full tax relief is available on employee contributions in the pension scheme, up to a maximum amount of 100 per cent of employment remuneration.
Jessica Noonan writes on various personal finance topics including salary packaging and novated leases. Connect with Jessica on Google+ now!