Are you missing out on a lucrative workplace pension perk?

If your boss or head of HR asked if you fancied sacrificing some of your salary, you might be tempted to tell them where to go.

However, salary sacrifice can actually be a fantastic way of eking out your earnings and getting the best possible value from your pay – especially when it comes to pension contributions.

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According to research from Scottish Widows, the average worker could boost the value of their workplace pension by more than £41,000 by using salary sacrifice to make contributions. Higher earners stand to see even bigger gains.

However, despite the impact that salary sacrifice can have on our future financial security, Scottish Widows’ research suggests only 35% of workers are enrolled on their employer’s scheme. One in five (20%) don’t even know whether their employer offers salary sacrifice.

What is salary sacrifice?

Salary sacrifice, or salary exchange as it’s sometimes called, involves swapping a portion of your salary for an alternative non-cash benefit. This could be a pension contribution, a company car, a bike as part of the cycle to work scheme, even a season ticket loan.

This reduces the amount of money you get paid in salary, but – and this is where the “magic” happens – it also means that you pay less income tax and national insurance (NI), meaning your actual take-home pay goes up, in spite of your “pay cut”.

And, in case you’re thinking your employer won’t be up for that, they pay less employer NI too – so there’s savings for everyone involved.

“The term ‘salary sacrifice’ is a red herring because neither the employer nor employee has to give anything up when they take advantage of this scheme. It’s truly a win-win,” says Susan Hope, retirement expert at Scottish Widows. 

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In many cases, generous employers, will be prepared to pass their saving on to their employees too as an additional workplace perk.

How it works

Let’s take a closer look at how salary sacrifice works in practice for pension contributions.

Sam earns £60,000 a year. She pays 5% of her earnings into a pension, while her employer pays 3%.

Making her pension contributions the conventional way, Sam would have take-home pay worth £43,557.40 a year and contribute £4,800 to her pension.

Using simple salary sacrifice, her salary drops to £57,000 and her employer agrees to pass on its NI saving. However, thanks to the tax savings, her take-home pay actually increases to £43,617 despite the reduction, while her pension contribution jumps up by £450 a year to £5,250.

Alternatively, if Sam really wants to prioritise her pension, she can choose “smart salary sacrifice”, where all her savings are passed on to her pension. This means her take-home pay remains at the same level, but her pension contribution shoots up to £5,368.97 – an additional £568.97 a year.

Scottish Widows, meanwhile, in its research, uses the example of the “average” worker, taking home £37,430, a year. If they use salary sacrifice, their take-home pay goes up by £150 a year and they get an additional £528 in their pension.

If this worker starts using salary sacrifice at age 30 and retires at 67, they’ll be better off to the tune of £41,200 by the time they retire – more than a year’s salary (calculation assumes 5% investment growth net of charges).

Bonus sacrifice

Less well known than salary sacrifice is bonus sacrifice. If you get bonuses from time to time at work, you can also use the same strategy to boost the value of your windfall.

Tax on a bonus can feel brutal – especially if you’re a higher or additional rate taxpayer.

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Frazer James, a firm of financial advisers, points to the example of a higher-rate taxpayer earning £65,000 who gets a bonus worth £6,000.

If they decide to take the bonus with their salary, their bonus will be worth just £3,480 after tax and national insurance is deducted.

However, if they agreed for their employer to use bonus sacrifice, and pay it into their workplace pension instead, they would get the full £6,000 paid into their pot – providing a tax saving of £2,520.

This can be a particularly helpful strategy if you’re approaching a painful tax-cliff edge. For example, if you’re on the verge of becoming a higher or additional rate taxpayer or a parent facing the high-income child benefit charge.

It can also help you swerve the 60% tax trap that occurs on earnings between £100,000 and £125,140, when tapering reduces the value of your tax-free personal allowance at a rate of £1 for every £2 you earn over £100,000.

This is because, by increasing your pension contribution and reducing your taxable income until it’s below the relevant threshold, you can avoid paying tax on your bonus at the higher rate, while simultaneously increasing the value of your retirement pot.

You will likely have to pay tax on your bonus eventually, when you take it out of your pension. However, most people pay tax at a lower rate when they retire.

What to think about first

It’s hard to argue against the maths when it comes to conversations about salary or bonus sacrifice.

However, there are considerations to make first. For example, while salary sacrifice might make you feel better off, it will reduce the “official” salary that appears on your P60. That could have an impact on your ability to borrow, for example, as mortgage lenders will consider your salary when making lending decisions. It could also have a knock-on effect on your entitlement to certain benefits and reduce the level of life insurance you receive from work.

Higher earners will also need to keep the annual allowance for pensions in mind. The standard allowance for most people is 100% of earnings up to £60,000 a year. Some of the highest earners may have a lower tapered allowance (where adjusted income is over £260,000 and threshold income is over £200,000) ,which can limit annual, tax-relievable pension contributions to just £10,000. However, if you have some unused allowance from the previous three tax years, you may be able to pay in more by using carry-forward rules.

Alternatively, if you’re over 55 and have already made a taxable withdrawal from your pension, you may have triggered the Money Purchase Annual Allowance (MPAA), which means you’ll only be able to pay £10,000 a year into your pensions. Carry-forward rules can’t be used once the MPAA has been triggered.

Is salary sacrifice under threat?

There has been speculation that the government might scale salary sacrifice back in an attempt to raise revenue. This is partly because the recent hike to employer NI is making it increasingly attractive.

In May, HMRC published research conducted among employers that checked employers’ responses to three hypothetical scenarios for reforming salary sacrifice. Even though the research was conducted two years ago, under the Conservatives, its recent publication suggests that salary sacrifice is very much on the current government’s radar.

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The most palatable scenario for employers was one where salary sacrifice would continue in its current form, but with amounts of salary that could be exchanged, capped. Other scenarios included reining in tax and NI benefits.

Rachael Griffin, a personal tax expert at Quilter, hopes that the government will continue to support salary sacrifice. “Any restriction on salary sacrifice would likely be deeply unpopular, particularly given that income tax thresholds have been frozen for years, pushing more people into higher tax brackets. If reforms were implemented, millions of workers could be impacted.”