Techzone

What is salary sacrifice?

Salary or bonus sacrifice, sometimes also referred to as ‘salary exchange’, involves an employee agreeing to change their terms and conditions of employment relating to pay. Under their revised contract, the employee gives up some of their salary, or contractual bonus, in return for a non-cash benefit from the employer - for example, an employer pension contribution.

Normally, this is done to create income tax or National Insurance (NI) savings without reducing the overall value of an individual's benefit package.

Employers are not obliged to offer employees salary sacrifice arrangements. Individuals who are classed as self-employed can’t use a salary sacrifice for their own benefit, but they can of course offer it to their employees.   

Why use salary sacrifice for pension funding?

Using an effective salary, or bonus, sacrifice arrangement to fund a pension can produce significant financial benefits for both the employee and employer. 

Benefits for the employee

Reducing earnings usually means the employee will pay less income tax and NI than before and reduce the amount of their salary subject to income tax.

• There will only be NI savings on earnings sacrificed above the primary earnings threshold (£242 a week for tax year 2024/25) as no NI is paid on earnings below this level
• Cuts in earnings between the primary earnings threshold and the upper earnings limit (between £242 and £967 a week in 2024/25) produce a NI saving for the employee of 8%
• Cuts in earnings above the upper earnings limit produce a 2% NI saving for the employee

Because employee pension contributions qualify for tax relief anyway, using salary or bonus sacrifice to fund an employer pension contribution instead of receiving the pay then making the contribution personally doesn't produce any additional income tax saving. However:

• As there's an NI saving, the same pension contribution can be made at a lower cost to the employee - increasing their take home pay
• Alternatively, a larger pension contribution can be made without affecting the employee's net take home pay. Our practical guide 'Salary sacrifice funding options' demonstrates how these options work in practice
• There can be a cash flow advantage to making a contribution using a sacrifice agreement rather than as an individual. This is because the benefit of higher rates of tax relief is felt immediately. If an employee makes an individual contribution under ‘relief at source’ (as applies to personal pensions and SIPPs), they will usually have to claim any higher rate relief through self-assessment, which means full relief could be delayed for up to 22 months

Scottish residents

As Scottish residents are subject to different income tax rates and bands from the rest of the UK, the overall effect of salary sacrifice can differ.

NI limits are the same across the UK and are aligned with the UK’s higher rate tax threshold. 

However, there are now seven tax bands in Scotland with income tax rates ranging from 19% to 48%. These higher rates compared to the rest of the UK make salary sacrifice even more attractive to Scottish taxpayers.

Benefits for the employer

Cutting an employee's earnings usually means that the employer will pay less NI than before. Employers don't pay NI on pension contributions for employees.

• Employers usually pay NI on all earnings above the secondary earnings threshold (£175 a week in 2024/25), so they’ll normally see a saving of 13.8% of the sacrificed amount. (Employer NI contributions are different for employees under 21 and apprentices under 25)
• Many employees see the flexibility of having salary or bonus sacrifice arrangements available as a valuable benefit. This can help the employer attract and retain staff
• Employers often agree to share part of their NI saving with the employee by boosting their pension contribution

Tax relief on the contribution can be claimed as a business expense in the same way as if they had paid them a salary.

Possible drawbacks

There can sometimes be drawbacks for employees entering a salary sacrifice arrangement. For example:

• The employee might not be able to revert to their old (pre-sacrifice) salary if personal circumstances change. The employer would have to agree to a further change to the employee's contract of employment.
• The employee's ability to borrow could be reduced following their change in salary. This could affect the levels of mortgage, personal loan or credit card limit they can get - however, some lenders will base their calculations on the notional (pre-sacrifice) salary.
• Other salary related elements of the employee’s employment package, such as death-in-service cover, contractual pension contributions, defined benefit pensions, PHI cover, overtime pay or future salary rises, could be affected. However, many employers will base salary related elements of their employment package on a notional (pre-sacrifice) salary. 
• High earners - the potential annual allowance taper trap:
  
  The tapering of annual allowance for high earners adds a further complication that can mean salary or bonus exchange is counter-productive for some employees.
  
  These rules start to bite where ‘adjusted income’ exceeds £260,000. Adjusted income is total income chargeable to tax plus any employer contribution. Someone sacrificing salary will receive a lower level of taxable income but in return they will receive an employer contribution. The salary sacrifice arrangement won’t change the individuals adjusted income figure, unless the employer boosts the employer contribution by their NI saving.
  
  Salary sacrifice can affect the calculation of 'threshold income'. The annual allowance will not be tapered if ‘threshold income' is £200,000 or less, even if adjusted income exceeds £260,000.
  
  Threshold income is total income chargeable to tax, less any individual contributions. However, it also includes any contributions made by new salary sacrifice arrangements entered into after 8 July 2015.
  
  As a result, high earners with adjusted income over £260,000 could be better off making personal contributions rather than starting a new salary sacrifice arrangement. Personal contributions will reduce threshold income and if this is reduced to £200,000 or below, tapering is avoided.
  
  
• Low earners - Salary sacrifice isn’t usually beneficial to individuals with income below the personal allowance as they don't pay income tax. It’s generally more tax efficient for these individuals to make personal contributions to a ‘relief at source’ scheme (such as personal pension scheme or SIPP), as basic rate relief is added to the contribution even though no income tax has been paid. Also anyone with earnings below the primary earnings threshold (£12,570 for tax year 2024/25) will receive no NI saving if they sacrifice their salary. Please also see the section below headed 'How much can be sacrificed?'.
  
  
• Entitlement to some State benefits could be affected by the salary sacrifice.
  
  The qualification criteria for State benefits vary widely, so the effect that a salary sacrifice arrangement can have on benefit entitlement depends on the individual’s circumstances and the particular benefit involved.
  
  Entitlement to some benefits, such as statutory maternity pay, statutory sick pay, means tested benefits or tax credits, are earnings related. So agreeing to a pay cut under salary sacrifice is likely to have an effect on benefit entitlement.
  
  Some other benefits, including State Pension, depend on the individual's NI record. Entitlement to such benefits probably won't be affected by a salary sacrifice arrangement so long as the reduced earnings remain above the lower earnings limit (£6,396 for 2024/25).

The potential impact needs to be considered before entering into any such arrangement.

There can be drawbacks for the employer too. For example:

• Salary or bonus sacrifice can create extra administration
• If an employee is off work for a long period of time, the employer may have to continue paying the pension contributions in line with the contract of employment, even if the employee isn’t receiving sick pay or maternity pay

HMRC requirements for a valid sacrifice

To be a valid salary or bonus sacrifice arrangement:

• the employee's terms and conditions of employment must be changed to reduce their salary or bonus in return for contributions to their pension and
• the arrangement must apply to future earnings - it can’t apply to pay that has already been treated as received for tax and NI purposes

Salary and bonus sacrifice arrangements are often used to facilitate options under flexible benefit packages offered by employers. The contractual change is usually made electronically, with the employees agreeing to the sacrifice when they choose how to take their remuneration and benefits package.

However, it's also possible to document a salary or bonus sacrifice by an agreement letter, signed by both the employer and employee. The letter should mention both the reduction in salary and the non-cash benefit to be provided instead

HMRC doesn’t have to be told that salary or bonus sacrifice arrangements have been adopted. Nor is there a requirement to stick to the arrangement for a minimum of 12 months, as was once the case. But, in practice, many employers ask HMRC to comment to reassure themselves that their arrangements have been implemented properly and that they're accounting for the right amount of income tax and NI.

Consequences of invalid sacrifice arrangements

If HMRC decides that a sacrifice arrangement is invalid, it will treat the amount sacrificed as if it had been paid to the employee as earnings i.e. it will be taxable and subject to both employer and employee NI.

If the sacrifice is invalid, the contributions will be treated as a contribution made by the employee. These will qualify for tax relief, subject to the usual rules and limits, but there won’t be any NI saving.

How much can be sacrificed?

The only restriction is that employees must normally be paid at least the national living wage (or national minimum wage if under age 23) in each pay reference period. A pay reference period cannot be more than 31 days. So, it’s not normally possible for employees to sacrifice all of their salary for employer pension contributions under a salary sacrifice agreement.

However, this restriction does not normally apply to company directors.

More info:

HMRC’s Employment Income Manual - salary sacrifice guidance:  https://www.gov.uk/hmrc-internal-manuals/employment-income-manual/eim42750

National Living Wage/Minimum Wage rates can be found on GOV.UK’s website: https://www.gov.uk/national-minimum-wage-rates

Our Annual allowance technical guide has information on annual allowance tapering for high earners.