What is salary sacrifice? All you need to know

If you’ve heard the term “salary sacrifice” floating around your workplace or seen it in a job benefits package, your curiosity might be piqued. What is salary sacrifice? How does it work and is it something you should consider?

Salary sacrifice is a smart way to make your money work harder for you. Through it, you can reduce your tax bill while gaining valuable benefits at the same time. Like any financial decision, however, it’s important to weigh up the advantages and disadvantages before you decide whether it’s right for you.

Let’s take a look.

What is salary sacrifice?

A salary sacrifice (sometimes referred to as a salary sacrifice scheme or a salary exchange) is an arrangement between you and your employer where you agree to reduce your gross salary in exchange for a non-cash benefit. It’s like swapping part of your salary for something else of value, usually pension contributions.

While the name might sound a bit daunting (after all, who wants to sacrifice their salary?), the reality is that it could actually leave you better off. Through salary sacrifice, both you and your employer can save money through reduced National Insurance contributions, since you’re technically earning a lower salary. Plus, you might pay less income tax too, depending on your tax bracket.

For example, let’s say you earn £35,000 a year and decide to sacrifice £200 per month for pension contributions. Your taxable salary would reduce to £32,600, meaning you’d pay less in tax and National Insurance, while still getting the full value of the £200 invested in your pension.

How does a salary sacrifice work?

When you opt for a salary sacrifice arrangement, you’ll need to formally agree to change your employment contract with your employer. This is important because you’re technically taking a lower salary. But don’t worry — it’s not as daunting as it sounds.

First, you and your employer will agree on which benefit you’d like to receive instead of part of your salary. Again, we’ll use pension contributions as an example:

1. You decide how much of your salary you want to sacrifice — say £200 per month
2. Your employer reduces your gross salary by this amount
3. That £200 goes directly into your pension pot before any tax or National Insurance is deducted
4. Your payslip will show your new, lower salary
5. Your employer may even add some of their National Insurance savings to your benefit, making the deal even better

Again, because your pension payments never technically hit your pay packet, they’re not subject to tax or National Insurance contributions at the time of payment. This means you’re saving on both, while still getting the full value of your money in the form of the benefit you’ve chosen.

One of the requirements of salary sacrifice is that it mustn’t take you below the National Minimum Wage. Your employer should confirm this for you, but it's good that you’re aware, too.

If you’re an employer, the gov.uk website has useful information on salary sacrifice for employers here.

Salary sacrifice vs salary deduction

It’s worth taking a moment to distinguish between salary sacrifice and salary deduction. While they might sound similar, they work quite differently.

The key point about salary sacrifice is that the reduction happens before tax and National Insurance are calculated.

Salary deduction, on the other hand, is when money is taken from your salary after tax and National Insurance have been calculated. Think of it like any other deduction from your net

pay, similar to when you set up a direct debit from your bank account. You don’t get the same tax advantages because you're paying with money that’s already been taxed.

A salary sacrifice also requires a formal change to your employment contract because you’re agreeing to a lower salary. A salary deduction doesn’t change your employment contract. Your full salary remains the same; you’re just arranging for some of your net pay to be diverted.

Salary sacrifice: Benefits

OK, let’s take a look at some of the reasons why the salary sacrifice scheme is such an attractive option for many employees:

• It offers excellent tax and National Insurance benefits: Of course, the most immediate benefit is paying less tax and National Insurance. Because you’re reducing your gross salary, you’re automatically lowering the amount of income that gets taxed. Since both you and your employer pay less in National Insurance contributions, some generous employers even share their savings with you by adding them to your chosen benefit.
• You can choose from several benefits: Salary sacrifice can be used for various benefits, depending on your financial priorities. You might opt for:
  • Pension contributions
  • Electric cars
  • Childcare vouchers (this option is now closed to new applicants, but existing users can continue to use it)
  • Cycle-to-work schemes
  • Tech schemes
• There are often important savings: Many benefits offered through salary sacrifice would cost more if you paid for them directly from your net salary. For instance, the savings on an electric car lease can be substantial compared to a personal lease arrangement, and you might get access to better deals through your employer’s purchasing power.
• It can help with your future planning: For pension contributions especially, salary sacrifice can be a powerful way to boost your retirement savings. The tax efficiency means more of your money is working towards your future, which can make a significant difference over the long term.

What are the downsides of salary sacrifice pension?

Salary sacrifice is not without its disadvantages, however, and it’s worth being aware of them as you make your decision.

• It means you have a lower salary on paper: Since you’re officially reducing your salary, this can affect several things:
  • Mortgage applications might be trickier, as lenders will look at your reduced salary
  • Your redundancy pay could be lower, as it’s typically based on your new, reduced salary
  • Your maternity/paternity pay and other salary-linked benefits might be reduced
• It could affect your state benefits: If your salary drops too low, it might affect whether you’re entitled to a State Pension (you need to earn above the Lower Earnings Limit to build up qualifying years), statutory Sick Pay, and some state benefits that are earnings-related.
• There are protection considerations: Life insurance and income protection policies through work are often based on your salary. A lower salary could mean reduced coverage, though some employers will base these benefits on your pre-sacrifice salary. It’s worth checking this point with your employer.
• There are flexibility trade-offs: Once you’ve set up a salary sacrifice arrangement, you typically can’t change it until the next renewal period unless you have a qualifying “lifestyle event” like getting married or having a baby. This reduced flexibility might be challenging if your financial circumstances change unexpectedly.

Quickfire summary: Is salary sacrifice any good?

A salary sacrifice is an arrangement where you agree to reduce your gross salary in exchange for a non-cash benefit. This typically saves both you and your employer money through reduced tax and National Insurance contributions.

Is it worthwhile? The tax efficiency of the scheme means you could get more value from your earnings, especially when it comes to pension contributions or big-ticket items like electric cars. However, it’s not a one-size-fits-all solution. While the tax savings can be substantial, you need to weigh these benefits against the potential impact on things like mortgage applications, statutory payments, and workplace benefits that are linked to your salary.

Before you decide, consider your personal circumstances carefully. And if in doubt, chat to a financial adviser who can look at your specific situation and help you make the best decision.

Also read:

• Everything you need to know about your P45 vs P60
• What’s the P11D deadline?
• When does the tax year start in the UK?

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