Income tax for employees
By Joe Elvin
Article 6 of 9
Discover how salary sacrifice can help you cut childcare costs, boost your pension or access certain workplace benefits at a lower cost.
Giving up part of your salary might sound like a strange idea, but it can make financial sense.
What is salary sacrifice?
Salary sacrifice enables you to exchange part of your salary for a non-cash benefit.
This reduces the amount of income tax and National Insurance you pay on your salary, as well as the National Insurance contributions your employer makes.
Salary sacrifice is commonly used to boost your pension, but you can also give up salary in return for benefits such as bikes, childcare vouchers, mobile phones and bus passes.
It's the tax-free fringe employer benefits (as opposed to taxable ones such as company cars) that are typically the subject of salary sacrifice schemes.
If your salary is reduced, it can affect state benefits. You should check with your employer to make sure your bonuses, pay increases and pension benefits won't also be affected.
Find out more: 30 ways to save on tax – a wealth of tips to save you even more money
Increasing your pension with salary sacrifice
You can reduce your income tax and National Insurance (NI) contributions by giving up part of your salary and directing it to your pension instead.
In the example shown, the employer would save on NI contributions (£128) and might be persuaded to add this saving to the contribution, boosting the amount paid towards your pension even more.
How it works
Here's how it might work for someone earning £25,000 during 2016-17, where both employee and employer pay 3% of the salary into a group personal pension scheme (GPP). The employer cuts the amount paid in salary by £1,000 but makes a corresponding additional contribution to the employee's pension fund.
Before salary sacrifice
- Employee contribution: 3% of £25,000 (£750 plus tax relief): £900
- Employer contribution: 3% of £25,000: £750
- Total contribution: £1,650
After salary sacrifice
- Employee contribution: 3% of £24,000 (£720 plus tax relief): £864
- Employer contribution: 3% of £24,000 plus £1,000 from salary sacrifice: £1,720
- Total contribution: £2,584
- Increase to pension contribution because of salary sacrifice: £934
- Less difference in take home pay: £680
- Net boost to pension: £254
Childcare vouchers and salary sacrifice
It's common for employers to allow parents to exchange part of their salary for tax-free childcare vouchers, which you pass on to your childcare provider.
Both parents can claim, effectively doubling the benefit, and higher-rate taxpayers save even more. However, if you are claiming tax credits to help with the cost of your childcare, you might lose out if you claim childcare vouchers.
How it works
Here’s how it could work for someone earning £30,000 a year in 2016-17 and claiming the maximum childcare vouchers of £243 a month:
- Tax and NI paid on salary of £30,000 during tax year:
- Tax and NI paid on salary of £30,000 where max of £243 a month (£2,916 a year) is paid in childcare vouchers: £5,499.68
- Saving over the tax year: £933.12
Find out more: childcare vouchers explained – how do childcare vouchers work?
Salary sacrifice and bikes
Many employers allow their employees to use Cycle To Work schemes to save money on the purchase of a bicycle.
You start by choosing the bike you want, which is bought by your employer who then leases the bike to you. Many employers can reclaim the VAT and have the option of passing this saving on to the employee. The employee's salary is reduced by the net cost of the bike for the hire period.
After the hire period ends, you can buy the bike from your employer at a 'fair market value' set by HMRC. After one year, this is 25% of the bike's original value for bikes costing more than £500, or 18% of the bike's original value for bikes that cost less than £500. If your hire period is longer than a year, you can buy the bike for less.
Combined with the reduction in tax paid on your salary, this can result in huge savings.
Flexible benefit packages
Some employers offer flexible benefit packages, which allow employees to buy extra or different benefits from the ones the employer offers as standard.
For example, you might choose to buy additional life insurance or critical-illness cover, or to extend benefits such as private health insurance or health screening to your partner. You can also choose to 'buy' additional holiday, or, if you prefer, give up holiday in return for extra cash.
These schemes are sometimes known as 'cafeteria benefits' or 'flex plans', and essentially they allow employees to vary their pay and benefits package in order to suit their own personal requirements.
You may be able to get benefits such as extra life insurance or critical-illness cover more cheaply by buying through your employer, as your employer is able to 'bulk buy'.
- Last updated: April 2016
- Updated by: Joe Elvin