Salary exchange has a clear monetary benefit for lower rate taxpayers, who save 13.25% of their NI costs (from April 2022). For higher rate taxpayers, the savings are lower: only 3.25%. So, is it worth opting in?
Yes. Opting into salary exchange can have two major benefits for your tax arrangement:
No need to claim back tax if you've got a relief at source pension
With a relief at source pension, higher rate taxpayers who have not opted into salary exchange need to claim back 20% of their tax via HMRC, in addition to getting another 20% of tax relief that your pension provider applies for. However, this changes when you opt into salary exchange, and is actually easier to manage.
Example for relief at source without salary exchange:
Salary: £70,000 pa
Pension contribution: 5%
Pension contribution amount: £3,500 yearly of which you are eligible for £1400 of tax relief, i.e. 40% of the pension amount.
How this actually works is that, after you have paid tax, you put in £2,800 from your net pay into the pension, your pension provider claims back £700 of the tax you’ve already paid and puts this into the pension, and you would need to claim your other £700 from HMRC.
So £3,500 goes into your pension (£2,800 + £700) and you get £700 in your bank account. The total tax relief is £1400.
With salary exchange:
With salary sacrifice, your pension is essentially operating as a net pay arrangement. This means the money for your pension is taken out of your gross salary before tax. As a result, the taxable amount is reduced by the same amount as you would have claimed back in the relief at source example. This means your tax relief is instant rather than delayed.
So £3,500 still goes into your pension, but all of it comes from your gross salary i.e. you do not pay any tax to HMRC, so there is nothing for your pension provider or you to claim back.
You’ll pay the same amount of income tax on an annual basis, because your amount of tax relief is still the same (40% of your contribution). However, on a monthly basis the amount of tax you pay is lower because the £700 you would have had to claim back is not being taken away in the first place. In other words, by opting into salary exchange, you get the tax relief right away rather than needing your provider and you to claim it back. .
A Net Pay arrangement is generally recommended for higher rate taxpayers for this reason - it reduces your administrative burden because you don’t need to make the claim.
Reduce the impact on your personal tax allowance
Once your earnings go above £100k, your personal tax allowance will decrease by £1 for every £2 you go above this limit. So, reducing your headline salary through salary exchange will help you preserve more of your tax allowance.
To recap the advantages of opting in to salary exchange:
Don’t need to manually claim tax relief - it happens instantly
If your earnings go over £100k, the reduction to your personal tax allowance won’t be as severe
3.25% NI saving over the year as long as your salary remains above the higher rate threshold which is £50K currently. If you become a basic rate payer, the NI savings jump to 13.25%