Is it worth swapping a bonus for additional pension contribution?

In this example, we aim to highlight the benefits to employees and directors alike of sacrificing salary increases or bonuses in favour of additional contributions to their pension.

It is worthwhile considering people who are likely to receive bonus payments throughout the tax year rather than just in the run-up to the end of the tax year or the date salary increases are made.

What is salary sacrifice?

A salary sacrifice arrangement is an agreement to reduce an employee’s entitlement to cash pay, usually in return for a non-cash benefit. In this case, additional contributions to the company pension.

The Government has chipped away at some of the benefits previously offered by employers through sacrifice of salary or bonus, but they are still a tax-efficient way of getting money into a pension plan. This is particularly the case if the employer is prepared to augment the salary/bonus given up by the National Insurance Contribution that it would have had to pay on it.

Where to start?

To start the process, the sacrifice must be documented by way of a formal declaration by the employee to give up their rights to a future cash payment in return for the employer contributing to a registered pension scheme.

By giving up the right to the cash payment, the employee obviously does not receive it and therefore does not pay tax on it. Neither would they be subject to the National Insurance Contributions on the amount given up.

Similarly, by making a payment as a pension contribution to a registered pension scheme for the employee, instead of as salary, the employer would also not be subject to their own employer National Insurance Contribution payments.

HMRC should treat the employer’s pension contribution as a legitimate business expense for corporation tax purposes, as they would have the salary/bonus payment to the employee.

EXAMPLE A

• Charlotte is a high earner with a salary of £100,000 and has been awarded but not yet entitled to payment of a £10,000 bonus.
• As this bonus will push her into the earnings threshold where she loses £1 tax allowance for every £2 earned, she will suffer an effective tax rate of 60% on the bonus.
• She will pay a further 3.25% employee National Insurance Contribution, resulting in net cash in her hand of £3,675.
• Instead, her employer makes a £10,000 payment into her personal pension plan. It augments this by the 15.05% employer’s National Insurance Contribution it would have paid, had this been a salary/bonus payment.
• The total employer contribution to the pension plan is therefore £11,505.

Outcome:

Taking this sum in isolation: if there was no growth on it up to the point at which Charlotte draws upon it and any pension income payments fall into her 40% income tax band, she could receive:

• Tax-free Pension Commencement Lump Sum (25%) = £2,876.25
• Income payment (£8,628.75 x 60%) = £5,177.25

Charlotte could receive a total of £8,053.50; more than double the net bonus given up. This sum could be higher still by factoring in any tax-free growth within the pension plan, or if income payments fell into the 20% tax band.

EXAMPLE B

It is not only high earners that will benefit:

• Lindsay has a salary of £35,000 and has been awarded but not yet entitled to payment of a bonus of £10,000.
• Income tax of 20% and her National Insurance Contribution (13.25% at this earnings band) will reduce her bonus payment and so her net cash in hand payment would be £6,675.
• As in the previous case study, the employer could instead pay a pension contribution of £11,505.

When Lindsay draws upon this sum, assuming income falls into her 20% tax band, she could receive the following:

• Tax-free Pension Commencement Lump Sum (25%) = £2,876.25
• Income payment (£8,628.75 x 80%) = £6,903
• Lindsay receives a total of £9,779.25, an uplift of over 46% on the net bonus she could have had instead.

Pro’s & Con’s

It is worth remembering that sacrificing salary or bonus could have disadvantages because of the lower amount of earnings. For example, it could reduce the amount that a mortgage lender would be willing to lend to the individual.

You should take particular care when advising clients who could be subject to the tapered annual allowance. In these circumstances, salary/bonus sacrificed might still count towards the individual’s adjusted income, in which case their annual allowance would be reduced accordingly.

If you would like further information, or would like to speak to one of our experts, please get in touch.