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Salary sacrifice in brief
Salary sacrifice is an arrangement where an employee agrees to reduce their contractual salary in exchange for a non-cash benefit, most commonly employer pension contributions. It can be used to make pension contributions through an employer arrangement.
While this can generate Income Tax and National Insurance efficiencies, it may also impact salary-related benefits, borrowing capacity and pension allowances, and should be considered within the context of an individual's overall financial planning.
This article is for general information only and does not constitute financial or tax advice. Tax treatment depends on individual circumstances and may change in future. If you are unsure whether salary sacrifice is right for you, we recommend seeking professional financial advice from a regulated financial adviser.
At Rathbones, we have over 100 financial planners across the UK – for a no obligation conversation, please get in touch.
What is salary sacrifice?
Can you explain what salary sacrifice actually is?
Of course. At its simplest, salary sacrifice, sometimes called a salary exchange, is an agreement between you and your employer to reduce your contractual salary by a certain amount. In return, your employer provides a non-cash benefit of equivalent value.
For most people, that benefit is an increased employer pension contribution, though it can also cover things like cycle-to-work schemes, childcare vouchers or electric vehicles.
The key word here is “contractual”. This isn’t just an informal arrangement. It requires a formal change to your employment contract, which is something people don’t always realise.
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What is a salary sacrifice pension?
What exactly is a salary sacrifice pension, and how does it work in practice?
A salary sacrifice pension is simply a workplace pension that is funded, at least in part, through a salary sacrifice arrangement. Instead of making pension contributions from your salary after it has been paid to you, you agree to reduce your contractual salary by a specified amount and, in return, your employer makes an additional pension contribution on your behalf.
In practice, you agree with your employer on the amount you want to sacrifice. Your payslip will show a lower gross salary, and your employer’s pension contribution will be higher. The result, in terms of what goes into your pension, can be similar to a standard contribution, but the route it takes and the tax treatment along the way are different.
What are the potential benefits of salary sacrifice?
What are the main potential benefits of salary sacrifice?
There are several, and they can add up significantly for the right person in the right circumstances.
First, there’s the income tax saving. Because your gross salary is lower, you pay income tax on a smaller amount. For a higher-rate taxpayer, that’s a 40% saving on the sacrificed amount.
There’s also the National Insurance saving. Both you and your employer pay lower NICs, which can be a substantial benefit, particularly for higher earners.
If your employer passes on their NIC saving as an additional pension contribution, that can increase the amount going into your pension.
For some higher earners, reducing their adjusted income through salary sacrifice can help manage exposure to the tapered annual allowance, though this requires careful planning and professional advice.
What are the potential drawbacks of salary sacrifice?
What are the risks or downsides people should be aware of?
Salary sacrifice isn’t right for everyone, so it’s important to understand the trade-offs.
The most significant is the impact on salary-linked benefits. Your contractual salary, the lower post-sacrifice figure, is what employers and lenders see. That affects things like death-in-service benefits, income protection insurance, statutory maternity and paternity pay, and redundancy calculations. If those benefits are important to you, reducing your contractual salary could leave you worse off at a difficult time.
There’s also the question of flexibility. Once you’ve agreed to a salary sacrifice arrangement, changing it isn’t always straightforward. Most employers will allow changes at certain points in the year, but it’s not as simple as adjusting a direct debit.
Is there an HMRC salary sacrifice limit?
Is there a specific HMRC limit on salary sacrifice?
There isn’t a specific “salary sacrifice limit” set by HMRC in the same way there is for ISA contributions. However, several rules effectively limit how much you can sacrifice.
The most important thing is that your post-sacrifice salary cannot fall below the National Living Wage (or National Minimum Wage, depending on your age). Beyond this, the main constraint is the pension annual allowance, which limits the amount that can be contributed to your pension in a tax year while benefiting from tax relief.
It is also important to remember that your available annual allowance may not be the standard amount. Higher earners may be affected by the tapered annual allowance, while those who have flexibly accessed pension benefits could be subject to the Money Purchase Annual Allowance (MPAA). In some cases, unused allowances from the previous three tax years may also be available through carry forward.
Salary sacrifice and wider retirement planning
How should salary sacrifice fit into someone's broader retirement strategy?
Salary sacrifice is a tool, not a strategy. It works best when considered alongside ISAs, other investments, property, business assets, and any defined benefit pension entitlements. For those managing different types of assets, such as a portfolio of properties, a business, or a combination of defined benefit and defined contribution pensions, the interactions can be particularly significant.
For most people, the question isn’t simply “should I use salary sacrifice?” It’s “how much should I sacrifice, at what point in my career, and how does it interact with everything else I’m doing?” Ideally, salary sacrifice decisions are made as part of a broader retirement planning review, rather than in isolation.
Questions to ask before using salary sacrifice
Before entering a salary sacrifice arrangement, it’s worth pausing to consider a few key questions. These won’t give you all the answers, but they’ll help you have a more informed conversation with a financial adviser.
How much income do I need today?
Salary sacrifice reduces your take-home pay in the short term, even if it improves your long-term position. Make sure the reduced salary is workable for your everyday needs.
Could reducing my salary affect my borrowing or benefits?
Think about mortgage applications, death-in-service cover, income protection, and statutory pay. If any of these are important to you in the near term, understand the impact before you commit.
Am I close to pension allowance limits?
If you’re already making substantial pension contributions, or your employer is, check whether additional contributions through salary sacrifice could push you over the annual allowance. The tax charge for exceeding it can be significant.
Does this arrangement fit my wider retirement plan?
Salary sacrifice is most effective when it’s part of a coherent pension and financial planning strategy. Consider how it sits alongside your ISAs, other savings, and your overall retirement timeline, and whether it has been reviewed in the context of a full retirement planning conversation.
When to seek financial advice
Salary sacrifice can be a valuable planning tool, but it works best when it’s tailored to your individual circumstances. The more complex your income, the more important it becomes to take professional advice before making changes.
This is particularly true if you’re a higher earner navigating the tapered annual allowance, or if you’re self-employed or a company director with a more flexible income structure. Professional advice can also be valuable if you’re approaching a significant life event, such as buying a property, starting a family, or planning for retirement. The same applies to a liquidity event such as a business sale.
At Rathbones, our financial planners work with people to understand the full picture, not just the pension, but the tax position, investments, goals, and life stage. To explore how salary sacrifice fits into your retirement planning, speak to one of our financial planners.
Key takeaways
- Salary sacrifice is commonly used for pension contributions.
- It may offer tax and National Insurance advantages in some circumstances.
- It can reduce contractual salary, borrowing, and workplace benefits.
- Higher earners should consider pension allowance limits.
- Salary sacrifice should be reviewed as part of a wider retirement plan.
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