Salary exchange for a pension contribution

Introduction

This briefing sets out the points to consider when using salary exchange to pay contributions to pensions, including the criteria to meet, tax considerations and other important issues.

Core considerations

• Salary exchange is where an employee gives up part of their salary or bonus before it is paid to them in return for that amount to be paid as a pension contribution.     
• The salary given up is treated as an employer contribution. 
• The amount exchanged by the employee is not chargeable to income tax or national insurance because it is given up before it is received. This means that there are extra National Insurance savings to be made, and by contributing this way all tax relief is received immediately. 
• The amount of an employee’s salary or bonus is reduced by the amount exchanged which means it can have an impact for anything that is calculated based on the amount of an individual’s salary/bonus received.    
• However, employers can record a notional salary ignoring the amount exchanged, which can be used in certain calculations to remove the impact of this.  
• For a salary exchange to be effective it must meet the criteria set down by HMRC. 

Contents 

• Salary exchange 
• HMRC requirements 
• Notional or reference salary 
• Other issues to consider
• National insurance contributions
• An example

Salary exchange

This happens when an employee exchanges the right to part of the cash remuneration due under their contract of employment, in return for the employer’s agreement to provide the employee with some form of non-cash benefit such as a pension contribution. The exchange is achieved by varying the employee’s terms and conditions of employment relating to their remuneration.  
 

HMRC requirements

For a salary exchange arrangement to be effective the remuneration must be given up before it is treated as received for employment income tax purposes. For an employee this will normally be the earlier of the date the payment is made and the time the individual becomes entitled to the payment. If the payment relates to a company director what also needs to be considered is when the remuneration was credited in the company accounts or records as well as the accounting period to which it relates. A bonus can also be successfully exchanged as long as it is made before the bonus is treated as received for employment income purposes. 
 
Secondly there must be a revised contractual arrangement between the employer and employee which means that the employee is entitled to lower cash remuneration and benefit. This can be achieved by setting out the agreed changes in a letter or pro-forma that is attached to an employee’s contract. Alternatively, a contract can be re-written in whole or in part or employees can be informed of proposals to make changes by the employer.   
 
HMRC’s employment tax manual section EIM42700 sets out guidance in relation to salary exchange. In particular, EIM42785 sets out an example of a successful salary exchange in relation to contributions to a pension scheme and EIM42786 sets out an unsuccessful example. 
 
A salary sacrifice arrangement must not reduce an employee’s cash earnings below the National Minimum Wage. 
 

Notional or reference salary

The pre-exchanged level of cash salary can be held by an employer to work out an increase in pay, to calculate overtime rates, to work out entitlement to holiday or sick pay and/or to provide information about earnings to a mortgage lender. This does not invalidate the salary exchanged, provided that the employment contract has been effectively varied as noted above. 
 

Other issues to consider

Having lower earnings after the exchange includes possible impacts on the maximum mortgage a lender will allow (as lenders could choose not to use a notional salary even if one is held). 
 
This could also affect group or individual personal health insurance cover depending on the formula used by the provider. 
 
Potentially pension benefits could be impacted such as a reduced pensionable salary under a defined benefit scheme or reduced employer contributions because of a lower pensionable salary under a money purchase scheme – this will depend on what the employer decides and what the scheme rules say.  
 
Other employer salary-related benefits could also be affected, such as group life assurance or group critical illness benefits, depending on whether the employer chooses to use a notional salary or not. 
 
As salary exchange reduces national insurance contributions this could also have an impact on certain state benefits. For example, state pension, statutory sick pay and earnings-related benefits such as statutory maternity pay. 
 

National insurance contributions

Lower national insurance contributions for both the employer and employee are paid because of a salary exchange arrangement. As this can provide an added benefit an employer might also agree to add the employer’s national insurance savings as an additional pension contribution, providing an increased benefit to employees. 
 

Example

Robert is an employee earning £75,000 per annum and is a member of his employer’s group personal pension plan. He pays 8% of his salary into the scheme and this is matched by his employer. Robert has spoken to his employer and is looking to exchange 8% of his salary instead of making personal contributions.

This will increase his take home salary as he will pay national insurance on a £6000 lower salary amount. Robert’s employer is also willing to pay the employer’s national insurance savings as an additional contribution for Robert (this is not always the case). Robert’s employer pension contribution will continue to be based on his notional salary, pre salary exchange. As an additional option Robert is also considering maintaining his current take home pay and increasing his pension contribution further.

The details based on 2023/24 income tax and National Insurance rates are set out below, the rates take account of the reduction announced in the Autumn Statement of 2% on the Standard rate of employees NICs from January 2024: 

Robert can benefit from a small uplift (0.245%) to his take home pay and an increase of just under 7% to his pension contribution by adopting a salary exchange approach.

If he looks to maintain his take home pay, he can achieve an increase of over 9% to his pension contribution.   

Income tax and National Insurance is calculated as follows (using current position before salary exchange as the example): 

Employer NI

£75,000 salary (NI savings only with salary exchange options).

Salary above secondary threshold of £9,100 = £65,900

NI at 13.8% = £9,094.20