What is salary sacrifice?

Salary sacrifice is an employment arrangement in which an employee agrees to forego a portion of their salary or wages in return for a non-cash benefit, such as a company car, additional vacation days, or contributions to a retirement savings plan.

How does salary sacrifice work?

To set up a salary sacrifice, the employee and employer need to agree on what portion of the employee’s earnings will be swapped for which benefit. The employee will typically sign a salary sacrifice agreement, which outlines the terms of the arrangement. Afterward, the employer will deduct the agreed-upon amount from the employee’s salary payments and use those funds to provide the benefit.

What does salary sacrifice mean for tax and National Insurance contributions?

Because salary sacrifices are deducted from pre-tax salary, employees save income tax and National Insurance on the sacrificed amount.

For example, let’s say an employee receives $450 per week and $50 of that salary is sacrificed for childcare vouchers. $400 is subject to tax and National Insurance contributions. Essentially, salary sacrifice can result in lower National Insurance contributions for employees. This can help them keep more of what they earn.

Does salary sacrifice reduce an employee’s taxable income?

Yes. When an employee agrees to forego a portion of their salary or wages in return for an employer-provided non-cash benefit, the employee’s taxable income is reduced by the amount of the salary sacrifice. This is because the employee’s salary or wages are the basis for calculating their income tax, and if they receive a non-cash benefit instead of cash, they will have less taxable income.

Salary sacrifice can also lower the employer’s payroll taxes, such as Social Security and Medicare taxes in the U.S or national insurance in the U.K. Employers pay these taxes on a portion of their employee’s salaries and wages, and if an employee’s taxable income is reduced through salary sacrifice, the employer’s payroll taxes will also be reduced on that portion of the salary.

Advantages of salary sacrifice for employers and employees

Employers and employees benefit from salary sacrifice. Here’s a list of benefits for both parties.

Employer salary sacrifice benefits:

• Increased employee satisfaction: Salary sacrifice can increase employee satisfaction and retention, as employees can save more of their earnings or receive valuable perks.
• Reduced National Insurance: Employers can pay less tax by saving money on their National Insurance contributions. Tax is not paid on sacrificed salary.
• Improved recruitment: Salary sacrifice can help attract and retain top talent. It’s often a valuable benefit for job hunters.

For employees:

• Lower National Insurance contributions: Salary sacrifice can lower National Insurance contributions for employees, helping employees save more of what they earn.
• Lower tax liability: An employee can lower their income tax liability by reducing their gross salary, saving money on their tax bill.
• Non-cash benefits: Salary sacrifice allows employees to receive non-cash benefits that may be unaffordable otherwise.

Disadvantages of salary sacrifice for employers and employees

Here are a few downsides of using a salary sacrifice scheme.

For employers:

• Administrative burden: The salary sacrifice scheme requires heavy administrative resources. Employers must adjust payroll systems, ensure compliance with regulations, and oversee ongoing monitoring and reporting.
• Compliance risks: Salary sacrifice schemes must abide by strict tax and employment law regulations. Any compliance error can result in penalties.
• Employee dissatisfaction: Not all employees benefit equally from salary sacrifice. Employees on lower wages see fewer advantages to these schemes because of minimum wage constraints. Additionally, a reduction in gross salary can affect entitlements like pension calculations.
• Impact on cash flow: Offering benefits through salary sacrifice could impact the company’s cash flow. For example, providing a company car involves costs that must be managed. This can strain financial resources.
• Challenges in communication: Communicating the details of salary sacrifice schemes to employees is often challenging. Employers need to ensure that all workers understand how these schemes work and the impact on their pay and benefits. Miscommunication can lead to confusion and lack of trust among employees, which can affect morale within the organization.

For employees:

• Reduction in other benefits: Salary sacrifice may affect an employee’s eligibility for other benefits based on their salary, such as overtime pay, bonuses, or redundancy pay.
• Impact on credit: Salary sacrifice can make it harder to certify income when seeking a loan or mortgage. This is because the employee’s gross salary is lower than their actual earnings.
• Reduced flexibility: Salary sacrifice agreements can be binding, which can limit an employee’s ability to change their arrangements if circumstances change.
• Tax implications: Salary sacrifice could affect an employee’s eligibility for tax credits or benefits like Working Tax Credit and Child Benefits.

What are the most common salary sacrifice schemes?

The most common salary sacrifice benefits are:

• Pension contributions
• Health insurance
• Childcare
• Transportation (car or public transportation expenses)
• Additional vacation days
• Gym memberships
• Mobile phone or internet subscriptions
• Professional development courses

Is there a limit to the amount of salary that can be sacrificed?

Yes. The limits vary depending on the benefit received and the country or jurisdiction in which the employee and employer are located. For example, in some countries, the limit for pension contributions is a percentage of the employee’s salary.

In the United States, the limit for 401k contributions in 2021 was $19,500, with an additional catch-up contribution of $6,500 for those aged 50 and over.

Can salary sacrifice schemes impact employees’ entitlement to government benefits?

Yes. Because salary sacrifice reduces an employee’s taxable income, it may also affect their eligibility for certain government benefits.

For example, if an employee sacrifices a portion of their salary for a pension contribution, it may reduce their entitlement to government pensions. Similarly, if an employee sacrifices part of their salary for childcare expenses, it may impact their eligibility for government-provided childcare benefits.