Saving taxes with salary exchange

Using salary exchange (also known as salary sacrifice) for deducting pension contributions enables employees in the UK to save towards their retirement while reducing their National Insurance (NI) contributions and income tax. Employers can benefit, too.

A smart workplace pension scheme has many benefits for employees:

  • Improving income levels at retirement and reducing the dependence on the basic state pension

  • Giving the employee the opportunity to retire earlier

  • Providing an opportunity for a better lifestyle at retirement

How it works

Instead of paying personal contribution into the pension after income tax and national insurance deductions, an employee’s gross salary decreases by the amount that they pay into the pension. As such, the taxable income is reduced. Subsequently, the employee saves income tax immediately at their marginal rate (opens a new window) (20%, 40% or 45%) and employee NI (opens a new window).

Reducing tax deductions

NI contributions increased (opens a new window) in April 2022. Using salary exchange can save someone earning £30,000 a year around £200 in employee NI, while someone on a salary of £50,000 may save around £330 in NI. In a time with additional demands on employees’ pay, using salary exchange as a method of paying pension contributions can make a considerable difference.

Data from pension and savings provider Cushon (one of the pension providers on our panel) shows that nearly two-thirds (63%) of savers are not aware of salary exchange, and of those that are, only 34% with a workplace defined contribution pension use it, suggesting that pension savers could collectively be missing out on £1.9bn a year. Employers can also reduce their tax bill by offering it, as the reduction in their employees’ gross pay also reduces the employer’s NI contribution. As a result, UK businesses could be losing out on as much as £2.1bn.

Things to know

  • Company benefits

While salary exchange is a contractual arrangement that reduces an employee’s gross pay; salary reviews and other salary related benefits continue to be based on an employee’s pre exchanged salary, which is often renamed as reference salary.

  • Loans/mortgages

Applications for loans, and mortgages are not usually impacted by salary exchange as typically applications are based on an employee’s reference (pre exchanged) salary or based on affordability.

  • Child benefit

A rarely discussed advantage of salary exchange is the impact it can have on child benefit and income tax. Child benefit can be claimed (opens a new window) for all children under the age of 16. The current benefit is £21.80 per week for the first child and £14.45 for each additional child.

A tax charge (opens a new window) is levied on the highest earner of the household if that person's taxable income exceeds £50,000 a tax year. Once it exceeds £60,000 the charge will be 100 per cent of the benefit claimed, thus negates the child benefit received. Whilst a parent can request that HMRC stop paying child benefit this does have a knock-on effect if the other parent is not working or does not earn enough to pay NI contributions. Child benefit can give an employee NI credits (opens a new window) which count towards the state pension.

An option is for the higher earner to make additional pension contributions using salary exchange, which then reduces their taxable income to below the income threshold, allowing them to continue to receive child benefit. You can find a child benefit tax calculator here (opens a new window).

When it may be unsuitable

There are circumstances where the use of salary exchange is not suitable, these include the following:

  • Employees at, close to or at the minimum national wage

  • Those wishing to pay off student loans quicker

  • Employees who may be planning to take maternity/extended parental leave

How to set it up

There are two ways an employer can set up salary exchange:

  • Contractual whereby everyone automatically has their pension contributions deducted via this method, and the employee or their employer opts them out if their pension contributions (and other salary exchange related benefits) bring their monthly income below minimum national wage,

  • Opting into salary exchange, by completing an employer’s opt in form or using their online benefits platform (where in place) and agreeing to the terms and conditions.

Employers looking to discuss and set up salary exchange for their employees; please contact:

Debbie New, Senior Pension Consultant

M +44 (0)7810 591916

E (opens a new window)