How to take members' pension payments
In principle, those payments which represent members' payments are made by deducting an amount from their pay and putting it into their pension plan.
There are three different ways of doing this. These are determined in part by the type of pension scheme you are using. They are:
- Salary sacrifice, also known as salary exchange (available to both contract-based and
- Before-tax deduction, also known as a net payment arrangement (only available to trust-based schemes)
- After-tax deduction, also known as relief at source (only available to contract-based schemes)
A pension plan is a long-term investment so its value can fall as well as rise and your members could get back less than was paid in. Laws and tax rules may change in the future. A member's personal circumstances and where they live in the UK will also have an impact on tax treatment.
First let's look at salary sacrifice (sometimes called salary exchange). It means your employees agree to give up part of their before-tax salary (which can include any bonus payment) in exchange for a payment into their pension plan, equal to the before-tax pension payment they would normally make. You then add your employer payment and the total is paid into their pension plan. The full payment is referred to and treated as an employer payment.
The main point here is that a lower salary figure is subject to National Insurance contributions (known as NICs), and so take-home pay is higher. And from the employer point of view, you pay NICs on the employees' salaries but not on their pension payments due to salary sacrifice, so reducing the employees' salaries in exchange for pension payments would mean less NICs for you to pay.
Salary sacrifice example:
Let's assume your employee’s basic pensionable salary is £25,000 and they contribute 5% as a pension contribution.
With salary sacrifice, instead of paying £1,250 into their pension plan after tax and NI is calculated, they exchange (or sacrifice) £1,250 of their gross salary and this is paid directly into their pension plan by their employer.
This means their salary now becomes £23,750 for the purposes of National Insurance and income tax. And because they then pay less NI and income tax on this reduced salary, their take-home pay can be higher or their pension payment can be increased.
Salary sacrifice sounds attractive, but be aware that it may not be right for some employees, and all employees need to give permission for this. It's a change to their terms of employment contract and could affect their state benefits, other company benefits or their ability to borrow. If they do not currently pay tax, it may not be the best option for them. However there are other payment methods you can offer to your employees; you don't just have to pick one.
Deductions from after-tax earnings
Next, let’s look at payments made from after-tax earnings. This way the pension payments are deducted from an employee’s after-tax earnings, and your employer payment is added on. Basic-rate tax relief is then added on from the government.
Deductions from after-tax earnings example:
In England, and in Wales at present, for every £80 an employee pays in, the government adds another £20 – so in total, £100 can go into their pension plan.
In Scotland, it’s a similar principle with a range of slightly different tax rates to take into account – but the same 20% benefit applies.
Across the UK, if your employees pay more than the basic rate of tax, they can claim additional relief from the government. For example, for a higher rate taxpayer in England, for every £80 they pay in, the government pays £20 in to their pension plan and reduces the tax they pay overall by another £20. Again, the rates and amounts will differ slightly in Scotland but the benefits are the same in principle.
The main point to remember from the employee point of view is that if they're paying into a pension plan, they benefit from government tax relief as well as any employer payment.
Finally, we’ll look at before-tax deduction. This means that your employee’s payments will be deducted from their salary after National Insurance has been calculated, but before income tax, which in turns means that they’ll pay income tax on a lower amount.
Before-tax deduction example:
In England, and in Wales at present, if they're a basic rate taxpayer and they want to make payments of £100 a month, £100 is taken from their salary before their tax liability is calculated. So - in terms of income tax, a basic-rate taxpayer can normally expect to pay £20 less, a higher rate taxpayer £40 less and an additional rate taxpayer £45 less (although the tax benefit could vary depending on their personal circumstances).
In Scotland, there are different rates in place, but the principle is the same.
As with after-tax deduction, the principle is that the employee is entitled to tax benefits on those earnings which are paid into a pension plan. The main thing to note about before-tax deduction as a method is that an employee's personal tax rate position is taken into account immediately, rather than after tax has been paid. And be aware that if the employee doesn't pay tax, this may not be the best option for them.