Sacrificing some of your salary can put more cash on the table

Salary sacrifice may not sound too appealing but it is set to become a potent weapon in the fight back against tax changes coming into force in April.

An estimated 1.6 million people will pay more income tax as the level at which the higher rate band kicks in is lowered, starting in April. The Institute for Fiscal Studies estimates that 750,000 people will be lifted into the 40 per cent tax band when the threshold is cut from 43,875 to 42,475.

And it will result in another 850,000 being dragged into the higher bracket by 2014, under the government's proposals.

Those earning 150,000 or more have already seen their income tax rate jump from 40 to 50 per cent, as of last April, while this April's rise in national insurance contributions from 11 to 12 per cent means the hunt is truly on for ways of softening the tax blow.

One option is to reduce your taxable income by asking your employer to divert your earnings into other benefits, a move that some experts say will increasingly widespread over the coming years.

This is known occasionally as salary exchange but more commonly as salary sacrifice.

What are the advantages?

Salary sacrifice allows you to reduce your pay in exchange for non-cash benefits such as pensions and childcare.

Take a simple example of someone earning 43,000 a year, which after April will be in the higher rate bracket.

If they decide to salary sacrifice 1,000 and boost their pension, the salary is reduced to 42,000, with the employer instead paying the 1,000 into their pension plan.

Not only does this mean the employee may be kept below a higher tax band, but they also pay less in national insurance contributions (NICs), which are based on the new, lower salary. At the same time their retirement savings are given a useful boost.

Proposed changes to child benefit - the benefit is set to be scrapped in 2013 for families where at least one parent is a higher rate taxpayer - add to the appeal of salary sacrifice, given the potential to move below the 40 per cent tax band.

High earners above the 100,000 threshold at which personal allowances start to be reduced, under changes made last April, can also benefit.

Why would my employer do it?

Not all companies offer salary sacrifice, which tends to be available in larger organisations. But a growing number are doing so because it allows them to improve the incentives package they can offer employees without having to increase cash rewards.

The other big draw for companies, especially this year as NI rates rise, is that they save on NICs because the employee's income is reduced.The majority of firms generally agree to pass that saving on to the employee., on request.

Martin Campbell, tax specialist at law firm Anderson Strathern in Edinburgh, said: "Most medium-sized and large employers have some form of salary sacrifice option - it's pretty widespread.

"Employers see it as a way to incentivise staff where previously they would have done that through financial rewards."

What benefits can I use?

The standard offers are childcare vouchers, pensions contributions, bike-to-work initiatives, gym membership, healthcare and save-as-you-earn schemes (where employees can exercise share options at a future date).

But remember that benefits-in-kind can have their own tax implications, so look carefully at what you're offered.

What can I save?

That depends on your earnings and whether it takes your salary into a lower tax bracket.

Campbell said: "If you structure it in the right way and use the right benefits, then it's financially beneficial for both the employer and the employee.

"It is particularly effective where it enables someone to keep below a tax threshold."

Not everyone can make savings through salary sacrifice, according to Fraser Smart, northern region director at Buck Consultants in Edinburgh.

He said: "For most staff there will be an overall gain but for low earners, entitlement to some state benefits and certain work-elated entitlements (maternity, paternity and adoption pay and statutory sick pay) may be unacceptably reduced or lost.

"If you are dropping from the 40 to the 20 per cent tax rate there can be very significant savings, especially if it is combined with tax-efficient benefits such as pensions."

Some people eligible for tax credits may be able to claim an increase due to the reduction in pay, he added.

Smart said: "At the other end of the pay scale those earning over 44,000 a year (42,500 in the 2011-12 tax year) will see less in personal savings because of the lower employee NIC rates above that level."

How long should I keep the arrangement?

That really depends on individual circumstances and on your employer (especially if you move to a new one).

But once you have sacrificed some of your salary you can't claim it back in the same way.

Campbell at Anderson Strathern said: "Once you are in salary sacrifice, unless there are other circumstances outwith your job where you need the money, it's a clear benefit."

What are the drawbacks?

There are several potential disadvantages, so if you're considering going down the salary sacrifice route it's important to seek employment advice and, where appropriate, tax advice.

"For salary sacrifice to be effective you have to disclose it to HM Revenue & Customs and if there are changes in your contract you have to get it right," said Campbell.

The most obvious consequence of salary sacrifice is a reduction in your pay, so you need to be sure thatyour finances don't suffer as a result.There are less obvious implications, however.

These include reduced life cover, as it is usually based on your salary, while those applying for a mortgage need to bear in mind that salary is the basis for the amount you can borrow.

The state second pension is calculated using earnings and a salary reduction could affect your entitlement, which could even be lost if the change takes you below the lower earnings limit (currently 5,044).

Entitlement to benefits such as sick pay, maternity pay and, in the longer run, the state pension could be similarly undermined by changes to earnings and NIC levels.