If you’re interested in making the switch to salary exchange, it might be helpful to see some examples of how exactly the cost-savings work.
How salary exchange works - in a nutshell
Salary exchange is a change in the way pension contributions are arranged. Normally, an employee contributes money from their salary AFTER they’ve been taxed, and the employer puts their contribution into the pension too. But, with salary exchange, the employer makes both contributions, and the money comes out of the employee’s salary BEFORE tax is applied. This pre-tax deduction means both employer and employee stop paying National Insurance contributions on the employee’s pension contribution amount. It also means that tax relief is applied at the time of payroll, rather than needing to be claimed by either the pension provider or the employee.
Let’s break that down so you can see an example for both employer and employee:
Savings for the company
Let’s imagine a tech company, Sigma. Sigma has 50 employees on an average salary of £35,000. They make the default minimum pension contributions (5% from employees and 3% from the employer), on the basis of full pensionable salary.
By switching to salary exchange, Sigma would stop paying National Insurance on the employees’ pension contributions. That’s a saving of 13.8% of the contribution amount. If all employees opted in, Sigma would save £12,075 per year. And, if the employees all raised their pension contributions by 1% (a key step on Maji’s pension coaching journey), Sigma would save an extra £2,415, making a total of £14,490. And that’s just the start - as the employees increase their contributions over time, Sigma will save even more.
Sigma could choose to keep these savings, use them to invest in employee wellbeing, or return these savings to employees in the form of higher pension contributions.
Savings for a lower rate taxpayer
Now let’s look at the savings for one of Sigma’s employees. Bobby earns £30,000, and normally contributes 5% of their full pensionable salary into their pension. The pension scheme is a relief at source arrangement, which is the default for many pension providers.
| Without salary exchange | With salary exchange |
Employee pension contribution | 4% of salary = £1,200 1% tax relief claimed by pension provider = £300 Total = £1,500 | 0% |
Employer pension contribution | 3% of salary = £900 | 8% of salary = £2,400 |
Amount exchanged out of salary | £0 | £1,500 |
Gross earnings | £30,000 | £28,500 |
National Insurance tax paid | £1,742 | £1,592 |
Income tax paid | £3,484 (Income tax paid on pension contributions is later reclaimed by pension provider) | £3,184 (No income tax to pay on the pension) |
Take-home pay | £23,574 (30,000-1,200-1,742-3,484) | £23,724 (28,500 - 1,592 - 3,184) |
You can see that Bobby makes a saving on National Insurance contributions. This is because their gross earnings are lower due to the pre-tax deduction, so Bobby won’t pay the 10% NI levy on their pension contribution amount. This means that although Bobby’s gross earnings look lower on paper, in reality, they take home that 10% of their contribution. In this case, it means Bobby gets an extra £150 each year.
The other important thing to note is that Bobby will pay the same amount of income tax in both scenarios. That’s because income tax is not levied on pension contributions anyway, hence why tax relief is applied. What differs with salary exchange is when that relief is applied. In a scenario where salary exchange is not used, and the employee is in a relief at source pension scheme, the tax is paid and then must be claimed back. In salary exchange, the tax is never paid and so doesn’t need to be claimed. In effect, the tax relief is immediate. Because someone in salary exchange won’t be paying the tax at all, rather than paying and then claiming back, their monthly payslip will show them paying less income tax. Over the course of the year, however, the amount of income tax paid will work out to be the same.
Savings for a higher rate taxpayer
Some of Sigma’s employees are paid enough to make them higher rate taxpayers. Tony earns £55,000 a year and normally contributes 5% of their full pensionable salary into their pension.
For a higher rate taxpayer, the National Insurance savings are only 2% of the pension contribution amount.
| Without Salary Exchange (Relief at Source) | Salary Exchange |
Employee contribution | 4% of salary = £2,200 1% tax relief claimed by pension provider = £550 Total = £2,750 | N/A |
Employer contribution | 3% of salary = £1,650 | 8% of salary = £4,400 |
National Insurance contribution | £3,864 | £3,809 |
Income tax (including pension tax relief) | £9,428 | £9,428 |
Gross earnings | £55,000 | £52,250 |
Take-home pay | £39,508 | £39,563 |
Tony might not get a huge amount of extra take-home pay, but there are a couple of big advantages to opting in that apply particularly to higher rate taxpayers. Firstly, they won’t need to manually claim back their extra tax relief from HMRC each year. Secondly, reducing their gross earnings can help them avoid the cap for personal tax allowance if their earnings are over £100,000 a year. Also, they might also be able to reduce the High Income Child Benefit Charge if their salary sacrifice starts reducing their earnings below £60,000.
Summary
This gives you an idea of the savings possible for an employer and their employees on different tax levels. These savings happen because National Insurance is not levied on the pension contribution when it is deducted before tax. It’s a small change that can give employees more change in their pockets and give an employer some extra money to play around with.
Maji simplifies switching over by automating and digitising the process so you can make the change both easily and legally. Maji also coaches users to increase their pension contributions, which further increases the benefits of salary exchange.
If you have any questions about salary exchange, please don’t hesitate to get in touch with us at www.maji.io. Hit the pink chat button in the corner of the page and we’ll get back to you as soon as we can.