What is Salary Exchange?
Salary exchange also known as Salary Sacrifice is a common way to make tax efficient pension contributions via your employer.
Put simply, it’s an agreement between you and your employer where you exchange part of your gross salary for a pension contribution. It works in the same way as other salary-related benefits you might get, like a company car and cycle to work.
When it comes to your workplace pension, the main benefit is you pay less income tax, and you and your employer pay less National Insurance Contributions (NIC). This is because your salary is reduced before tax and NIC are taken.
Employee Tax Relief Savings
As an employee agrees to reduce their gross salary in exchange for pension contributions, Income Tax is charged on the lower amount. For example, if an employee earns £30,000 and sacrifices 5% of their salary (£1,500) they will only be charged Income Tax on £28,500.
This means for a basic rate tax payer they would get 20% (£300) tax relief on their £1,500 contribution. Higher tax rate payers would receive 40% tax relief. To help make this clearer, we’ve provided an example below based on a basic rate tax payer.
| No Salary Sacrifice | Salary Sacrifice | |
|---|---|---|
| Salary Exchange | £0 | £1,500 |
| Gross Salary | £30,000 | £28,500 |
| Tax (20%) | £3,186 | £3,186 |
| Employee NI Contributions | £1,394.40 | £1,274.40 |
| Employee Pension Contribution | £1,500 | £1,500 |
| Take Home Pay | £23,919.60 | £24,039.60 |
We’ve used the above figures as an example to show you how salary exchange works based on tax and National Insurance rates for the 2023/24 tax year. Remember, the tax you pay depends on your individual circumstances and where you live in the UK and may change in the future.
Is Salary Exchange Right For You?
Paying into a pension using salary exchange might not be right for everyone. Here’s some things to think about:
- You won’t be able to exchange part of your salary if it means it’ll drop below the National Minimum Wage or National Living Wage
- As your salary reduces when you agree to exchange part of it, it could affect your entitlement to other benefits like statutory sick pay. You should speak to your employer for more information about this
- If you’re a higher rate taxpayer you could benefit from higher tax and NIC savings
- Your lower salary might affect the amount of money you’re able to borrow for a mortgage
- The rules about salary exchange may change in the future. If you’re not sure if salary exchange is right for you, it is best to speak to your financial adviser.