Could salary sacrifice boost the value of your pension and help you retire early?

You might initially hear the term “salary sacrifice” and think it sounds counterintuitive. You wouldn’t want to give up a portion of your salary since you’ve worked so hard to achieve it, after all.

Don’t judge a book by its cover – salary sacrifice can offer several financial benefits, especially regarding your tax liability and retirement prospects.

Yet a survey from the Actuarial Post found that while 60% of DIY investors said their employer offers salary sacrifice, only 29% made use of the scheme.

There are some drawbacks to this agreement to consider, too, and it’s important to be aware of these before you proceed.

So, continue reading to find out how salary sacrifice works, and discover whether it may be right for you.

“Salary sacrifice” involves exchanging a portion of your income for other benefits

Salary sacrifice is a government-backed initiative that involves reducing your income in exchange for non-cash benefits, so long as you and your employer agree to this before it comes into effect.

Some of the benefits you receive could include:

• Employer-provided healthcare

• Gym membership and other wellbeing perks

• Financial protection

• Independent financial advice

• A company car

• Pension contributions.

One of the more popular forms of salary sacrifice is the final point on the above list: receiving additional employer contributions to your pension.

When you sacrifice some of your salary under this type of agreement, your employer contributes the equivalent amount directly into your pension.

This allows you to build your retirement savings without paying National Insurance (NI) or Income Tax on the sacrificed portion. You may also receive tax relief on the additional amount your employer puts in, building your pot up even more as you head towards retirement.

An example published by Standard Life reveals just how impactful increased employer pension contributions could be. The research says that just a 2% increase in employer contributions could leave savers £115,000 better off in retirement.

It’s worth noting that while some salary sacrifice benefits – such as pension contributions – are free from Income Tax, others may still be taxed as “benefit in kind”.

This means that certain non-cash benefits could still trigger an unexpected tax bill later down the line, so it’s vital to fully understand how your employer’s scheme works before committing to it.

Here are some more benefits and drawbacks to consider in greater detail.

2 key benefits of salary sacrifice

1. It could help you stay in a lower tax bracket

On the topic of tax, salary sacrifice could make your income more tax-efficient.

For example, the higher-rate tax band starts at £50,270 (including the tax-free Personal Allowance of £12,570), and this threshold has been frozen until at least 2028.

If you currently earn £50,000 a year and are offered a 5% pay rise, your salary would increase to £52,500, pushing the top end of your income into the higher-rate tax band.

With salary sacrifice, rather than taking the full £2,500 increase as taxable salary, you could instead choose to have it contributed to your pension.

This would allow you to:

• Maintain the value of your pay rise without crossing the higher-rate threshold

• Reduce your Income Tax and NI payments

• Build up your retirement fund.

Essentially, salary sacrifice means you could enjoy the financial benefits of a pay rise without losing some of it to higher tax rates.

2. You may be able to increase your take-home pay

You might be surprised to learn that salary sacrifice can sometimes increase your take-home pay, all while bolstering your retirement fund.

This is because instead of receiving income that would normally be subject to NI and Income Tax, an allocated portion of your income goes straight into your pension.

Income Tax and NI are calculated after pension contributions, so your bill may decrease, and your take-home pay may then rise as a result.

An example from the Times Money Mentor explains this in detail.

• If you earn £30,000 a year, you will normally pay 5% of your salary into your pension, with your employer contributing an additional 3%.

• If you opt for salary sacrifice, you could reduce your gross pay by £1,500 using pension contributions, bringing your taxable salary down to £28,500.

• Your employer then contributes this £1,500 directly to your pension, plus their usual £900.

• Not only would this reduce your Income Tax bill to £3,186 and your NI payments to £1,911.60, but your take-home pay would rise, as the table below demonstrates.

Source: The Times Money Mentor 

A rise in take-home pay is not guaranteed, as this depends on your earnings and many other factors. Contact a professional for a personalised illustration.

There are some impactful drawbacks of salary sacrifice to keep in mind

While salary sacrifice does offer some notable advantages, there are some potential downsides to consider.

1. You may end up with less cover

Since a life cover payout is typically calculated based on your income, salary sacrifice could affect the amount your loved ones would receive if you unexpectedly passed away.

The same goes for income protection and critical illness cover, both of which may also be calculated based on your income.

2. Lower take-home pay could affect your ability to borrow money

Salary sacrifice could also affect your ability to borrow money. For example, mortgage lenders often assess affordability based on your salary.

If lenders see a lower salary, they may believe you’re less likely to be able to meet your financial commitments, affecting your ability to secure a loan. So, you could end up with a higher interest rate or even be ineligible to borrow the amount you want.

3. It may affect certain pension arrangements if you decide to move schemes

If you work in the public sector and have a defined benefit (DB) pension, sacrificing part of your salary could affect how your pension entitlement is calculated.

If you leave the scheme within the first two years, you may not be able to get a full refund on contributions, as they’re technically considered employer contributions.

Even if you’re on a defined contribution (DC) scheme, you may only be eligible for a refund if you opt out within 30 days of joining, and even then, you might not be entitled to a full refund of any sacrificed contributions.

You may want to discuss salary sacrifice with a professional before agreeing to it

As you can see, while salary sacrifice could allow you to reduce a potential tax bill and grow your pension, it isn’t without its complications.

Your unique circumstances will determine whether salary sacrifice is the right choice for you, which is why it’s worth speaking to a financial planner before you make any decisions.

We could help you navigate the tax implications of salary sacrifice, weigh up the potential downsides and, ultimately, structure your income in a way that suits your long-term goals.

Email info@athertonyork.co.uk or call us on 0208 882 2979 to find out how we can help.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

All information is correct at the time of writing and is subject to change in the future.

Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance. 

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts. 

Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation, and regulation, which are subject to change in the future.

The Financial Conduct Authority does not regulate tax planning.