Higher tax and National Insurance from 2011 isn’t inescapable. There’s a nifty dodge that could leave millions of employees better off.
The wheeze is ‘salary sacrifice’, which is simply the employer paying money into your pension scheme instead of paying it to you as salary. Up to now, it’s only been large companies that have installed such schemes, but they’re going to get a lot more popular. And why not, when you can end up getting the same net take-home pay but have more money paid into your pension plan?
Salary sacrifice is going to get simpler because the thresholds for income tax and National Insurance are being brought into line. From next April, the Upper Earnings Limit, above which your employee National Insurance contributions fall from 11% to 1%, will be £43,875. Deduct next year’s personal allowance of £6,475 (the first band of income on which you pay no tax) and you get £37,400, which is the starting point, in taxable income, of the 40% higher income tax rate.
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Politicians fudge the issue
So the ‘marginal rate’ for the employee on annual earnings from £6,475 up to £43,875 is now 20% (income tax) plus 11% (NI), making 31%. But in reality, the employer’s NI contributions are simply another tax on take-home pay. Add this 12.8% (with no upper limit) and you end up with a marginal tax of 43.8%. Politicians fudge this issue all the time, but this is why we are right to feel we are heavily taxed in this country: the true marginal tax rate on income from employment is 43.8%.
That is for a standard rate taxpayer: for a higher rate taxpayer the marginal rate is 53.8% - only 10% higher, because the employee’s rate of NI drops from 11% to 1% on earnings above the Upper Earnings Limit.
It’s the high rates of NI that make salary sacrifice work. To keep it simple, take the case of someone earning £30,000 a year, so they pay income tax at 20%. If they get paid £1,000 a year less, they pay £200 less in income tax; they pay £110 less in NI; and their employer pays £128 less in NI. With most salary sacrifice schemes, the employer would pay £1,238 into the employee’s pension fund - the salary ‘sacrificed’ plus all the NI savings.
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Less tax, more pension
Now in that example the employee would be worse off in terms of net pay, but suppose the employee is contributing to the employer-sponsored pension scheme and is paying in £800 per month.
As a result of the scheme, the employee stops paying in to the pension plan, so their net take-home pay remains the same even though they’re paid £1,000 less (they’re paying £800 less pension contributions and £200 less tax).
I’ve used unrealistic figures just to keep it simple. In practice, salary sacrifice schemes usually juggle the figures so that the employee’s net pay stays the same, but the employer contributes more – usually 15-20% more - to the employee’s pension fund.
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Schemes will become more popular
According to Hargreaves Lansdown, only 13% of employers were offering salary sacrifice schemes at the end of 2007. But an awful lot more will probably be offering them soon.
The big wrinkle is that for salary sacrifice to work, the contract of employment has to be changed. That’s a bit tiresome from the employer’s point of view. Plus, each employee has to work out whether they’ll gain from the scheme before they decide to join.
Some won’t gain, because salary sacrifice has knock-on effects on entitlements to sick pay and retirement benefits. On the other hand, a lower salary may increase your entitlements to tax credits. That’s why most salary sacrifice schemes come with personal counselling from one of the bean counters who install the schemes.
High marginal tax rates always create a demand for escape routes. Despite their complexity,salary sacrifice schemes will proliferate simply because people want to sidestep rising levels of tax.
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