Although it is common practice to plan pension contributions in the run up to the tax year-end, it is worthwhile considering your clients who are likely to receive bonus payments throughout the whole tax year.
While the government has chipped away at some of the benefits previously offered by employers through salary sacrifice schemes, salary sacrifice or the sacrifice of earned bonus is probably the most tax-efficient way of getting money into a pension plan especially if the employer is prepared to augment the bonus given up by the National Insurance contribution that would have been payable on it.
To start the process, the sacrifice should be documented by way of a formal declaration by the employee to give up their rights to a future cash payment. The employer in return may then, using its discretion, make a contribution to a registered pension scheme.
By giving up the right to the cash payment, the employee obviously does not receive it and therefore does not pay tax on it. Neither would they be subject to the National Insurance contributions on the amount given up.
Similarly, the employer, by making a payment in lieu as a pension contribution to a registered pension scheme, would also not be subject to their own employer National Insurance contribution payments.
The contribution should still be treated as a legitimate business expense in the same way that the bonus payment would have and should therefore reduce the employer’s corporation tax in the same manner.
The following case study demonstrates the advantages:
Sandra
Sandra is a high earner with a salary of £100,000 and has been awarded a £10,000 bonus.
As this bonus will push her into the earnings threshold where she loses £1 tax allowance for every £2 earned, she will suffer an effective tax rate of 60% on the bonus. She will pay a further 2% employee National Insurance, resulting in net cash in her hand of £3,800.
Instead, her employer makes a £10,000 payment into her personal pension plan. It augments this by the 13.8% employer’s National Insurance it would have paid, had this been a salary/bonus payment. The total amount received by the pension plan is, therefore, £11,380.
Taking this sum in isolation: if no growth was achieved at all; Sandra draws upon it when she has retired and any income payments fall into her 40% income tax band, she could receive:
Pension commencement lump sum (25%) £2,845
Income payment (£8535 x 60%) £5,121
Sandra could receive £7,966; more than double the net bonus given up. This sum could be higher still by factoring any tax-free growth within the pension plan, or if income payments fell into the 20% tax band.
It is not only high earners that will benefit.
Robert
Robert has a salary of £35,000 and has earned a bonus payment of £10,000.
His bonus payment will be reduced by income tax of 20% but also by the employee National Insurance contribution, which at this earnings band are 12%. His net in hand payment would be £6,800.
Instead, as before, a pension contribution of £11,380 could be paid in lieu.
When Robert draws upon this discrete sum, assuming income falls into his 20% tax band, he will receive
Pension commencement lump sum (25%) £2,845
Income payment (£8535 x 80%) £6,828
Robert could receive £9,673, an uplift of more than 42% based upon the net bonus he could have received.
Pros and cons
However, sacrificing salary or bonus could have disadvantages in that earnings are reduced and thus the amount able to be borrowed for mortgage purposes, as an example, would also be reduced.
Care should also be taken for earners whose total threshold income is greater than £110,000 and who might otherwise be subject to the tapered annual allowance as in these circumstances, any earnings given up could still be counted towards the individual’s adjusted income and their annual allowance would be reduced accordingly.
Martin Tilley is director of technical services at Dentons Pensions Management