Salary sacrifice pensions explained

Salary sacrifice – or salary exchange – is an arrangement that allows you to exchange some of your salary for certain employee benefits. It is used for increased pension contributions but can also be used for benefits such as childcare vouchers and cycle to work schemes. 

Although the idea of sacrificing your salary may sound foolish, it can actually be rather good for your pension savings. In fact, salary sacrifice is sometimes known as the SMART (Save More And Reduce Tax) Pensions Scheme.  

What is a salary sacrifice pension?

A salary sacrifice pension allows you to exchange some of your salary, or a bonus or redundancy payment, for a contribution or regular contributions to your pension. 

As you have given up some of your salary, you reduce the amount of income tax and national insurance you pay. This means that a contribution into your pension costs you less than if it is made from your taxed pay. 

Your employer also pays less employers’ national insurance on your reduced salary. This could potentially add to the appeal of a salary sacrifice pension as, although some employers will pocket this saving, others will add some, or all, of it to your pension contribution. 

How does a salary sacrifice pension work?

Salary sacrifice is complicated so here’s an example to show you how it works.

Sam is a basic rate taxpayer earning £40,000 in the 2023/24 tax year and wants to pay £4,000 to their pension. Here's how that looks if Sam chooses to use salary sacrifice and without.

In this example, by using salary sacrifice, Sam is £320 a year better off. 

Without salary sacrifice

After income tax (£5,486.00) and national insurance (£2,194.40) are deducted, her take-home pay is £32,319.60.  

She wants to pay £4,000 into her pension. This costs her £3,200 as the government adds £800 in tax relief.  

Therefore, after the deduction of her pension contribution, she has £29,119.60 take-home pay.

With salary sacrifice

Her employer offers salary sacrifice and she arranges to sacrifice £4,000 a year from her salary for a pension contribution.  

Her reduced salary is £36,000. This means she pays £4,686.00 in income tax and £1,874.40 in national insurance, reducing her take-home pay to £29,439.60.  

She also has £4,000 in her pension as a result of the salary sacrifice contribution. 

As you can see, by using salary sacrifice, Sam has been able to reduce the amount of tax paid on their income and is £320 a year better off.

Not only this, but Sam's employer could also agree to pass on its national insurance saving. If they do, that's an additional saving of £552 (13.8% x £4,000). This increases the contribution to their pension to £4,552 and makes Sam £872 better off.  

What are the rules for salary sacrifice pensions? 

Salary sacrifice is a formal arrangement between you and your employer. There’s no obligation for an employer to offer a salary sacrifice pension but, as there are benefits for employers as well as employees, many do offer it. 

To set up an arrangement, you need to sign a salary sacrifice contract with your employer. This sets out how much of your salary you are giving up and what you will receive in return. 

A salary sacrifice arrangement should also allow you to make changes when a major lifestyle event such as marriage, divorce or starting a family, happens. Without one of these events in the background, switching terms whenever you want could risk invalidating any benefits of salary sacrifice. 

You are free to end the arrangement whenever you like, but your employer will need to amend your contract to reflect your revised salary.

What are the advantages of a salary sacrifice pension? 

• Your pension pot potentially grows faster – or at a lower cost to you.
• You reduce the amount you pay in income tax and national insurance and you may also benefit from your employer’s national insurance savings.
• Reducing your salary could increase your entitlement to certain state benefits such as tax credits.
• Salary sacrifice offers some tax planning opportunities. You may be able to regain child benefit entitlement if your income can be reduced below £60,000; or reclaim your personal allowance if you can sacrifice salary to get below £100,000.

What are the disadvantages of a salary sacrifice pension? 

• Your take-home pay may be reduced although, by using salary sacrifice to cover existing pension contributions, you could maintain or even increase your take-home pay 
• It could affect how much you can borrow on a mortgage or loan – but do check with your HR department as many lenders now accept your notional full salary rather than the reduced one. 
• It could affect earnings-related benefits such as maternity and paternity pay, income protection and life insurance. 
• A lower salary could also affect percentage-based pension contributions and pay rises. Ask your employer whether they will use your notional full salary or the reduced one for these calculations.
  

How much salary should I sacrifice for my pension? 

How much you sacrifice is up to you. The more you pay into your pension, the faster it will grow, but there are few things to consider before taking the plunge:

• Annual allowance – this is the lower of £60,000 and 100% of your income. Unless you are taking advantage of carry forward to pay in more, this is the most that can go into your pension in the current tax year before you have to pay tax.
• Your take-home pay – the tax and national insurance savings can make it tempting but don’t sacrifice salary you may need now. Also be aware how a lower salary might affect other benefits, although this can sometimes work in your favour.
• National minimum wage – a salary sacrifice arrangement cannot reduce your earnings below the national minimum wage rates. Your employer should have procedures in place to prevent this. 
  

How do I work out the effect on tax and national insurance contributions?

This will vary depending on your tax position and your employer’s policy on redirecting national insurance contributions saved as a result of salary sacrifice. 

Speak to your HR department or accountant to find out how a salary sacrifice pension could work for you.

Is there a catch? 

Salary sacrifice is a great way to boost your pension but it is possible that the rules could change in the future. Some of the tax advantages that come with salary sacrifice used to be available across a broader range of benefits, until restrictions were introduced in 2017. 

The government may target salary sacrifice again to help it balance the books, but salary sacrifice pensions could be safe as they help with another government objective – encouraging more retirement savings.