‘Salary exchange’ to boost pensions - Veterinary Practice
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InFocus

‘Salary exchange’ to boost pensions

Dylan Jenkins explains what ‘salary exchange’ is and how it can be used to advantage by both employers and employees to add value to pensions as well as improving the benefits’ package.

Boosting pension savings and increasing one’s retirement pot is never a bad idea. However, in these tough times, other financial requirements may supersede pension contributions, meaning many individuals might not be saving adequately for later life.

“Salary exchange” (also referred to as “salary sacrifice”) is a good way for you to increase your pension contributions without it actually costing you any more money. In this article I will provide a brief overview of how salary exchange works and lay out all the facts you will need to consider before deciding to opt into such an arrangement.

What is salary exchange?

In basic terms:

  • an employee agrees to give up some salary or bonus;
  • the amount given up is used by the employer to provide a non-cash benefit to the employee.

Because the employee is being paid less salary or bonus: the employer makes NIC savings; and the employee pays less tax and NICs.

Salary exchange can be used with any type of UK-registered pension plan: individual or group personal pensions, stakeholder plans, occupational money purchase plans and final salary schemes.

The first point to ascertain is whether your business offers a salary exchange facility, as not all employers do. To set up salary exchange within a pension plan, the employee exchanges an amount of salary that he or she would have otherwise paid to his or her pension plan. The employer then pays the amount exchanged to the pension plan as an employer contribution.

For example: employee earns £20,000 gross yearly; employee currently pays 5% of salary to a pension plan, or £1,000 yearly; employee exchanges £1,000 of gross salary; employer pays this £1,000 (plus any regular employer contributions) to the pension plan.

Pension contributions can be increased just by using salary exchange. Depending on how the NICs and tax savings that have been generated are used, there are several ways available. Many financial advisers can use a calculator to demonstrate the following four examples:

  1. None of the tax and NIC savings generated are reinvested into the pension plan: the employer does not reinvest the NIC saving so costs reduce; the employee’s take-home pay increases as he or she pays no income tax or NIC on the amount exchanged. The pension contributions stay the same.
  2. The employer decides to keep the NICs savings rather than reinvesting them into the pension plan; the employees reinvest their income tax and NICs savings into the pension plan: the employer does not reinvest the NIC saving so costs reduce and the employee can exchange slightly more salary than the normal pension contribution and keep his or her take-home pay at the same level. As more has been exchanged, this increases the pension contribution.
  3. The employer reinvests the NIC savings into the pension plan; the employees will keep their savings rather than reinvest them into the pension plan: the employer reinvests the NIC saving so costs stay the same and the employee’s take-home pay increases as hew or she pays no income tax or NIC on the amount exchanged. The employer’s NIC savings increase the pension contribution.
  4. The employer will reinvest the NIC’s savings and the employees will reinvest their NICs and income tax savings into the pension plan: the employer reinvests the NIC saving so costs stay the same and the employee can exchange slightly more salary than the normal pension contribution and keep his or her takehome pay at the same level. The increased employee contribution and the NIC savings increase the pension contribution.

Are higher rate and additional rate taxpayers affected?

This depends on whether the exchange is being set up in a personal pension/stakeholder pension plan or an occupational pension scheme as outlined below:

a. Personal pension/stakeholder pension (with tax relief given at source). In the vast majority of these plans, pension contributions are deducted from net pay – i.e. after tax has been deducted.

These pension contributions are then grossed up by the pension provider at basic rate only. The amount of higher-rate tax relief that can be claimed back depends on the individual’s tax position and his or her total taxable earnings.

b. Occupational pension scheme (net pay arrangement). In these schemes, contributions are normally deducted from gross pay, i.e. before tax – this has the effect of giving full tax relief on any pension contributions paid.

MORE QUESTIONS…

Will HMRC restrict or remove salary exchange arrangements in the future?

While there’s no straight answer to this, because it will depend on government attitudes going forward, HMRC has published guidance, together with questions and answers, on salary exchange.

It seems likely that, at least in the short term, the salary exchange mechanism will continue to be available.

How can an employer’s NIC savings that are generated through salary exchange be used?

The NIC savings the employer makes can be used in many ways. For example, they can be used to provide other employee benefits, increase pension contributions, shore up deficits in a defined benefit scheme, or the employer may simply keep the savings.

Remember, however, that the actual amount of salary that the employee exchanges MUST be used to provide a non-cash benefit to the employee, such as childcare vouchers, or – as we are discussing in this article – pension plan payments.

Can salary exchange be used with existing pension plans?

Yes, salary exchange can be introduced into existing, as well as new, plans.

Can the self-employed use a salary exchange arrangement?

No. As there is no employer to make a pension contribution on their behalf, the self-employed cannot set up a salary exchange arrangement.

How do employers set up a salary exchange arrangement?

Salary exchange is a change to the contract of employment and so some paperwork will be required in order to set up an arrangement. Ask your financial adviser for a guide to salary exchange: he or she should also be able to provide a calculator to show how your savings would stack up, along with examples of your options in this regard. More information can be found on the HMRC website: www.hmrc.gov.uk.

Is salary exchange suitable for all employees?

As salary exchange reduces gross salary, this can affect certain state and other benefits. Further information is available from HMRC’s Salary Exchange guidance.

In a very brief summary, HMRC guidance on salary exchange states that “for most employees paying less NICs may not adversely affect your benefit entitlement”. There are, however, potentially two groups of employees who may be more adversely affected by salary exchange than others: (1) employees who earn less than the NIC lower earnings limit (LEL) – £5,668 p.a. for 2013/14 tax year as those earning below this level will not accrue certain state benefits; and (2) women about to take maternity leave.

Can a salary exchange agreement be altered?

Yes, it can normally be altered: for example, if someone opts out of an automatic enrolment scheme with salary exchange. For any other circumstances it depends on how the agreement has been set up, so it is definitely worth checking with your employer before making any binding decision.

Can salary exchange reduce state and other benefits?

Yes, salary exchange can affect certain employer, state and other benefits but the impact can be mitigated in certain circumstances.

How does it affect mortgages and other borrowing?

Mortgage and other lenders may base the amount that they’re willing to lend on either a multiple of salary or affordability. Employers can provide lenders with details of an employee’s pre-exchanged salary; however, this may not be accepted. Employees considering borrowing should therefore discuss this with their lender before proceeding with salary exchange.

In summary

Salary exchange can provide employees with an ideal opportunity to add value to their pension and increase their retirement provision. For employers it is also an easy, efficient way to improve their employee benefits’ package.

It may not, however, be suitable for everyone and I strongly recommend you take professional advice before deciding whether it is right for you.

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