Using Bonus sacrifice to save taxJanuary 6th, 2014 by Dan Woodruff
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Read how Michael used bonus sacrifice to generate a 106% return into his pension instantly.
You can make huge savings in tax by using bonus sacrifice to pay into your pension plan. Are you a high earning employee who receives a bonus? Do you like paying Income Tax at 40% or 45% on this bonus, plus National Insurance? Probably not. This article explains more about the power of bonus sacrifice, and why you might want to consider this.
This article has been updated in line with changes to the annual allowance for high earners, which took place in April 2016.
- Bonus sacrifice is the most tax-efficient way of paying in to your pension plan
- Why consider bonus sacrifice?
- Bonus sacrifice for high earners may be more difficult
- How bonus sacrifice works in practice
- How Michael generated an instant return of 106%
- Practical considerations, including the tapered annual allowance for high earners
What is bonus sacrifice?
If you are a high earner, the chances are that you receive a basic salary as well as bonus payments. Typically, you will be offered the chance to sacrifice some of this bonus and instead have that money paid into your pension scheme. This is known as bonus sacrifice (also known as salary exchange).
Why consider bonus sacrifice?
Bonus sacrifice gives an immediate tax saving, since you are not taxed on the amount of bonus that you give up. Your total income is reduced and therefore you are only taxed on the income you actually receive. The part that goes into your pension plan is not taxed as it is instead an employer contribution. This means that you save on Income Tax at 45% or 40%, depending on your income level. You should also save National Insurance. In addition, your employer will not pay National Insurance on the amount of bonus given up – usually at 13.8%. in many cases employers are prepared to pass on some or all of these savings. If you earn above £100,000 your Income Tax personal allowance is reduced by £2 for every £1 earned above £100,000. This can mean an effective rate of tax of up to 60% for earnings between £100,000 and £118,880. By reducing your bonus you may be able to save even more tax.
Bonus sacrifice for high earners
The way that bonus sacrifice works for high earners has changed. Since April 2016 if your total income is greater than £110,000 you may be affected by the tapered annual allowance for high earners. This assesses your total income, including pension contributions such as bonus sacrifice. If the total is over £150,000 then you will lose your annual allowance for pensions progressively until at £210,000 income you will only have £10,000 available for pension contributions. Pension contributions over the tapered annual allowance are taxed at 45%. Read the article referenced above for much more information. In practice this means that it is much more difficult for high earners to use bonus sacrifice.
How does bonus sacrifice work in practice?
- Your employer informs you of the bonus entitlement
- You write a short letter to declare the amount of bonus you wish to sacrifice This decision cannot be reversed and should be legally binding to be valid. Your letter should declare the original salary and bonus, and detail the amount to be sacrificed in place of a pension contribution. The bonus must be given up before it is received to be effective. Together, these elements mean that your right to receive the cash element sacrificed has been removed.
- Your employer pays the sacrificed bonus into your pension plan as an employer contribution This contribution should be treated as a legitimate business expense and would therefore reduce the employer’s Corporation Tax.
- It is not necessary to inform HMRC, but it is good practice to do so
How Michael generated an instant return of 106%
Michael works in the City. Each year he gets an annual bonus. Typically, he is notified of this in January and the bonus is paid in March. His employer runs a pension scheme, so they offer bonus sacrifice as an option to save both of them tax. All he has to do is to let his employer how much of his bonus he wants to sacrifice and his employer and pension scheme handle the rest. Michael earns a salary of £130,000 per year, and pays 5% of this into his pension plan as standard monthly contributions. His employer pays the same. This year he has been awarded a bonus of £20,000. Michael’s salary and bonus means that he is a 45% Top rate Income Tax payer, and he is also hit by the rules for people earning over £100,000 who have their Income Tax allowance removed. He has decided to sacrifice all of his bonus. His employer will pay this figure into his pension scheme in March. His employer will also pay the National Insurance saved into his pension scheme as an employer contribution. Let’s examine the situation with and without Bonus Sacrifice. Please bear in mind that these figures as for illustration only as your situation will be different.
Without Bonus Sacrifice
Total earnings £150,000 Income tax £50,998 National Insurance £6,214 Total tax £57,212 Net pay £86,287
With Bonus Sacrifice
Total earnings £150,000 Bonus sacrificed £20,000 Income tax £42,998 National Insurance £5,684 Total tax £48,682 Net pay £74,817
Effect of Bonus Sacrifice
Net pay reduces by £11,470 Total tax reduces by £8,530 Additional contribution to pension plan is £23,657 Therefore, for a net cost to Michael of £11,470, he gets £23,657 into his pension scheme, a profit of £12,187 (or an instant return of 106%)! Tweet this
- Annual allowance You may be able to give up significant amounts of bonus. The maximum allowed to be paid into your pension plan is £40,000 in one tax year. This includes your employee and employer contributions. Therefore, if you sacrifice large bonuses you may go over this limit. You can use Carry Forward to use up unused allowances for the previous 3 tax years so long as you were a member of a pension scheme during this period. In theory, you could make an additional £140,000 contribution using this method. Be careful if you are a high earner and your total income (including pension contributions) is greater than £110,000. Check out our article on the tapered annual allowance for high earners, which reduces your pension allowances if you earn over £150,000. You could pay additional tax if you use bonus sacrifice after April 2016, which would negate the benefits highlighted in this article.
- Lifetime allowance The maximum allowed in pension schemes is £1 million from April 2016. If you pay in significant bonuses to your pension plan you need to be careful that you do not breach this limit since there are significant tax charges applied if this happens.
- Normal pension rules apply If you do a bonus sacrifice arrangement you will get all the usual advantages and disadvantages of pension plans. This means that the money will grow largely tax-free, but that you will not be able to access the funds until age 55 at the earliest. If you need access to the bonus money you might want to reconsider bonus sacrifice since you will lose access to the money if you pay it into your pension plan.
- Your employer might insist you use your company pension scheme Some employers insist that you pay your bonus into their pension scheme since this is easier for them to administer. This is not mandatory, and you can pay your bonus into any pension scheme if your employer is prepared to do this.
- Reduced bonus The fact that your bonus is reduced could impact you in other ways. For example, the amount you can borrow might be reduced. Alternatively, you might be entitled to other employee benefits on your total income (such as sick pay or life cover). If you reduce your bonus, these might be affected. Normally, employee benefits are calculated using your basic salary.
How does bonus sacrifice differ from standard pension contributions?
Bonus sacrifice is probably the most tax-efficient way of getting money away from PAYE into your pension plan. It is tax-efficient since you never get taxed on the income you do not receive. If we compare this to the normal personal pension contributions you make, these are made from your post-tax income. This means that you pay Income Tax and National Insurance at the standard rates. You then get 20% tax relief at source into your pension, plus 20-25% additionally via your tax return later if you pay income tax at 40% or 45%. Bonus sacrifice benefits you immediately and you also save National Insurance. If you pay into an occupational pension scheme, this is paid in via the net pay arrangement, which is different to the rules for personal pensions. You would still benefit from savings to National Insurance. Our article on pension tax relief explains more about how this works with standard pension contributions.
What to do next
If your total income is above £150,000 then bonus sacrifice may not be possible. If you are considering bonus sacrifice for this tax year, you should contact us now. Even if you earn less than £150,000 you may want to consider bonus sacrifice as a way to save tax and boost your pension contributions.