General questions about salary exchange

General questions about salary exchange
With the proposed increase in National Insurance contributions currently causing a political storm I thought it would be a good time to revisit one of my favourite subjects in relation to pensions. That of salary exchange. An already attractive proposition has just become even more so.

These questions and answers cover some of the most common issues on salary exchange. If there’s a question that you have that isn’t covered here, you can check HMRCs Salary Sacrifice Guidance or Salary Sacrifice Q & As Alternatively, you can e-mail me with your question. I’ll do my best to find out the answer and may post it on this website

What is salary exchange?
In basic terms:

• an employee agrees to give up some salary or bonus
• the amount given up is used by the employer to provide a non-cash benefit to the employee
• because the employee is being paid less salary or bonus:
  • the employer makes National Insurance Contribution (NIC) savings
  • the employee pays less tax and NICs.

What type of pension plan can salary exchange be used with?
It can be used with any type of UK registered pension plan – i.e. individual or group personal pension/stakeholder or occupational money purchase/final salary schemes. The main point to remember is that there must be an employer willing and able to make payments to the scheme after the exchange is made.

Can the self-employed use a salary exchange arrangement?
As there’s no employer to make a pension payment on their behalf, the self-employed cannot set up a salary exchange arrangement.

How can salary exchange be set up with a pension plan?
The employee exchanges an amount of salary that they would have otherwise paid to their pension plan. The employer then pays the amount exchanged to the pension plan as an employer payment. For example:

Employee earns £20,000 gross yearly
Employee currently pays 5% of salary to a pension plan – that’s £1,000 yearly
Employee exchanges £1,000 of gross salary
Employer pays this £1,000 (plus any employer payments) to the pension plan.

Can pension payments be increased just by using salary exchange?
Yes. Depending on how the NIC and tax savings generated are used, there are several options available. Our calculator can deal with the following four options:

1. None of the tax and NIC savings generated are used:

• Employer saves as they pay less NICs on a reduced salary.
• If it’s the current employee pension payment that’s being exchanged their take home pay increases as they are paying less tax and NICs, albeit on a reduced gross salary.
• Pension payments remain the same.

1. Employee take home pay remains the same:

• Employer saves as they pay less NICs on a reduced salary.
• If it’s the current employee pension payment that’s being exchanged, they can exchange slightly more so that their take home pay remains the same.
• The pension payment increases by the extra amount the employee exchanges.

1. The employer reinvests their NIC savings into the pension plan:

• Employer reinvests their NIC saving into the pension plan.
• If it’s the current employee pension payment that’s being exchanged their take home pay increases as they are paying less tax and NICs, albeit on a reduced gross salary.
• The pension payment increases by the amount of the NICs savings that the employer makes.

1. Employee take home pay remains the same and the employer reinvests their NIC savings into the pension plan:

• Employer reinvests their NIC saving into the pension plan.
• If it’s the current employee pension payment that’s being exchanged, they can exchange slightly more so that their take home pay remains the same.
• The pension payment increases by the extra amount the employee exchanges plus the amount of the NICs savings that the employer makes.

Higher rate and additional rate taxpayers can claim additional tax relief. Does this affect the salary exchange calculation?
This depends on whether the exchange is being set up in a personal pension/stakeholder pension plan or an occupational pension scheme:

Personal pension/stakeholder pension (relief at source)
In the vast majority of these plans, pension payments are deducted from net pay – i.e. after tax has been deducted. These pension payments are then grossed up by the pension provider at basic rate only. The amount that can be claimed back depends on the individual’s tax position and their total taxable earnings.

Occupational pension scheme (net pay arrangement)
In these schemes, payments are normally deducted from gross pay i.e. – before tax – this has the effect of giving full tax relief on any pension payments paid. Our calculator will show this where the individual is a higher rate or additional rate tax payer by showing the payment before the exchange as being deducted from gross pay.

Will HMRC restrict or remove salary exchange arrangements in the future?
Whilst there’s no straight answer to this as it’ll depend on Government attitudes going forward, HMRC have published guidance together with questions and answers on salary exchange. So it seems likely that at least in the short term, salary exchange will continue to be available.

How can any employer NIC savings generated through salary exchange be used?
The NIC savings the employer makes can be used in many ways. For example they can be used to provide other employee benefits, increase pension payments, shore up deficits in a defined benefit schemes, or the employer may simply keep the savings. Remember however that the actual amount of salary that the employee exchanges MUST be used to provide a non-cash benefit to the employee, such as childcare vouchers, or pension plan payments.

Setting up a pension salary exchange arrangement

Can salary exchange be used with existing pension plans?
Yes, salary exchange can be introduced into existing plan as well as new plans.

How do employers set up a salary exchange arrangement?
Salary exchange is a change to the contract of employment and so there’ll be some paperwork required to set up an arrangement. We can provide guides to salary exchange, guide for employees and personal calculator have more detail on this. Also, more information can be found in HMRCs Salary Sacrifice Q & As.

We’ve also produced a sample joiner pack where the employer can introduce salary exchange for all employees, however employees are given the option to opt-out of the salary sacrifice arrangement.

It’s important that any salary exchange arrangement is set up before the right to the salary actually arises to the employee. As an example of how this may be done:

November
Employer advises employees that they’re introducing a salary exchange arrangement and gives them the option to join or opt-out.

December
Employer deadline for receiving all completed joining or opt-out forms.

January
Salary exchange arrangement starts.

Is salary exchange suitable for all employees?
As salary exchange reduces gross salary, this can affect certain state and other benefits. I can cover this in more detail on request  and further information is available from HMRC’s salary exchange guidance.

HMRC guidance on salary exchange states:

“For most employees paying less NICs may not adversely affect your benefit entitlement…”

However there are potentially two groups of employees who may be more adversely affected by salary exchange than others. We would recommend that the employer considers carefully:

• Employees who earn less than the NIC lower earnings limit (LEL) – £5,044 p.a. for 2010/2011 tax year. Those earning below this level will not accrue certain state benefits. Employers may want to restrict salary exchange to those employees earning over a certain amount. This is sometimes known as a Pay Protection Limit. There’s no hard and fast rule as to what level of salary should be set as the Pay Protection Limit – it’s up to the employer to decide. Note that it’s not possible to reduce an employee’s salary to a level which after the exchange is lower than the National Minimum Wage.
• Women who are pregnant and about to take maternity leave. Because some maternity benefits are based on the salary after exchange, employers may want to restrict pregnant women from entering the salary exchange arrangement. Note however that it’s possible for the employer to top-up any loss of benefits due to salary sacrifice so that pregnant women can still benefit from the arrangement.

Do HMRC have to be told about salary exchange arrangements?
The only occasion where HMRC would want to look at a salary exchange arrangement is where it’s set up for less than one year. Otherwise, as salary exchange constitutes a change to an employee’s contract of employment, it’s not within the remit of HMRC and they do not have to be advised.

However HMRC are concerned that tax and NICs are deducted correctly. Employers have the option to contact HMRC if they want to make sure that they’re deducting tax and NICs properly after the salary exchange arrangement is in place. Details of how they can do this can be found in the Salary Sacrifice Q & As.

Can a salary exchange agreement be altered or terminated?
Not normally. The change to the employee’s contract of employment will normally last for the duration detailed in the agreement letter, usually 12 months, although this may be longer depending on how the agreement letter is drafted. A sample agreement letter is available in our guide to salary exchange.

However, certain ‘lifestyle events’ may allow the agreement to be terminated earlier than this. Lifestyle events are significant changes to an employee’s circumstance and are defined by the employer. Examples may include the birth of a child, divorce, a change to working hours or starting maternity leave.

Importantly, an employer can insist that the salary exchange continue until the end of the agreement even if a ‘lifestyle event’ occurs.

In addition, an employer may stipulate that exercising a lifestyle event within a certain period, say 3 months, from the agreement review date is prohibited.

Can salary exchange reduce state and other benefits?
Yes, salary exchange can affect certain employer, state and other benefits, some of which are listed below – note that this list is not exhaustive. The impact on benefits can however be mitigated in certain circumstances.

More information on how salary exchange can affect benefits can be found in our guide to salary exchange, guide for employees and sample joiner pack. Also, more information can be found in HMRCs Salary Sacrifice Guidance.

Salary, overtime, bonuses and other employer related benefits
Although salary exchange is a reduction in gross salary, the agreement can be constructed so that salary increases, bonuses and overtime for example are based on the salary before the exchange. This is commonly known as “notional” or “shadow” pay.

Mortgages and other borrowing
Mortgage and other lenders may base the amount that they’re willing to lend on either a multiple of salary or affordability. Employers can provide lenders with details of an employee’s pre-exchanged salary however this may not be accepted. Employees considering borrowing should therefore discuss this with their lender.

Student loans
Repayments of student loans are triggered where earnings are currently above £15,000. If a salary exchange reduces earnings to below this threshold then repayments may reduce or stop. This may mean that it’ll take longer to repay any student loan.

Basic State Pension (BSP)
The BSP is dependent on the number of contributions made in an individual’s working life rather than the amount of NICs. So provided an individual has at least 30 years of contributions, exchanging salary will not affect the level of BSP as long as the exchanged amount doesn’t reduce the individual’s earnings below the Lower Earnings Limit (LEL) for NICs.

State Second Pension (S2P)
S2P is an earnings-related benefit so you’d expect the S2P entitlement to reduce where an employee sacrifices salary. But that doesn’t apply in all cases:

• Those earning less than the NIC LEL – £5,044 p.a. for 2010/2011 – accrue no entitlement to S2P.
• Those earning between the LEL and the NIC primary threshold – £5,715 for 2010/2011 – pay no NICs but get S2P benefits as though they were earning the Lower Earnings Threshold (LET) – £14,100 for 2010/2011.
• Those earning between £5,044 and £14,100 get S2P as though they were earning £14,100.
• Those earning between £14,100 and £43,875 Upper Earnings Limit (UEL) get benefits based on actual earnings.
• Those earning above £43,875 get S2P based on £43,875.

Statutory Maternity/Adoption Pay (SMP/SAP)
SMP/SAP are based on gross earnings that are subject to Class 1 NICs and tax. As these earnings will reduce as a result of salary exchange, there’ll be an impact on SMP/SAP and they may also reduce.

It’s possible to avoid a reduction in SMP/SAP if an employee comes out of the salary exchange arrangement at least 23 weeks before maternity (or adoption) leave starts. The actual number of weeks will depend on the dates used by the individual’s employer. This would usually be done by exercising a ‘lifestyle event’.

If starting/stopping maternity or adoption leave is not an employer listed ‘lifestyle event’, SMP/SAP will be calculated using post-sacrifice earnings.

If the employer operates an occupational Maternity or Adoption Pay policy, they may increase payments up to or above the statutory amount to ensure the individual does not lose out.

Statutory Paternity Pay (SPP)
If earnings are reduced to less than LEL, there’s no entitlement to SPP.

Statutory Sick Pay (SSP)
SSP is a work-related payment which employees are entitled to by law and is not connected to their contract of employment.

If earnings fall below LEL then there’s no right to receive SSP. If this happens employees may still be entitled to income support based on incapacity or incapacity benefit, if they meet the qualifying conditions.

If the employer operates an occupational sick pay scheme, sick pay could still be paid through that scheme even if earnings are less than LEL to ensure employees are not worse off.

Tax Credits
The Working Tax Credit (WTC) and Child Tax Credit (CTC) were introduced in April 2003 to help families on middle incomes. The amount of WTC depends on a number of factors including the number of hours worked, how many children the employee has and the amount of eligible childcare costs.

Working Tax Credit is calculated on actual taxable earnings, so if these are reduced by a salary sacrifice, an individual’s WTC entitlement may increase.

As you can see Salary Exchange offers a way to increase pension contributions at little or no cost to both employer and employee but may not be for everybody. To find out if this can benefit you or your company please just drop me a line.

You can also apply for one of my guides on this subject by following this link:-  http://www.williamgeorgeifa.co.uk/downloads/

Tagged as: financial adviser, Investment Advice, salary sacrifice, Tax Advice