How to invest more money — and pay less tax

Would you like to invest a bit more of your money and pay less tax into the bargain? I’m assuming your answer is “yes”.

Tax rises next April as a result of the new health and social care levy are set to take an unwelcome bite out of pay packets. The chart below shows how much this could cost you — but it could also crimp your next pay rise.

Why? Both employer and employee pay national insurance contributions on wages. From next April, the basic rate that employees pay rises to 13.25 per cent, but employers are set to pay just over 15 per cent, raising labour costs at a stroke.

Economists warn this could act as a clamp on wage growth at a time of rising inflation, and have questioned the intergenerational fairness of the decision. Even if graduate workers repaying student loans are lucky enough to get a £1,000 pay rise next year, the combination of higher taxes and loan repayments could wipe out more than half of it.

So what legitimate steps can workers take to reduce their tax bills? Salary sacrifice is the answer — but it comes with some important caveats.

Essentially, salary sacrifice is a tax break to incentivise employees to save more for retirement.

Most big UK employers offer salary sacrifice arrangements on staff pension schemes. In wonk speak, they are an agreement to reduce an employee’s entitlement to cash pay in return for a non-cash benefit. In practice, employees agree to “sacrifice” a fixed percentage of their gross pay into the company pension scheme every month and, in return, they do not have to pay a penny of income tax or national insurance on that slice of earnings.

Once inside a pension, that money can then grow tax free until retirement, at which point you can take a 25 per cent tax-free lump sum, although income tax will apply to subsequent withdrawals.

Crucially, this also reduces national insurance bills for employers who won’t have to make contributions on the proportion of salary that you sacrifice. For this reason, tax experts predict the popularity of such arrangements will soar.

So following next April’s increase, how could the savings stack up?

I asked consultants PKF Francis Clark to come up with the following examples. In all cases, we assume the employer matches the first 6 per cent of pension contributions.

A worker earning £40,000 who sacrifices 6 per cent of their salary (£2,400) and gets the matched contribution (another £2,400) will be able to save £4,800 into their pension for a cash cost of just £1,602. The impact of the new levy adds £30 to the tax savings.

As you move up the salary scale, the tax savings become more substantial — especially if you are lucky enough to earn between £100,000 and £125,000.

A six-figure salary is an achievement to be proud of, but £100,000 is also the point at which the personal allowance (the tax-free slice of the first £12,570 of your earnings) starts to taper. When you cross the £100,000 threshold, you will lose £1 of this tax-free allowance for every £2 you earn.

This equates to a marginal tax rate of 60 per cent until you earn more than £125,140, at which point all of your allowance has tapered away — plus you’ll have to swallow the newly enlarged national insurance charges on top. Ouch!

But let’s say someone earning £120,000 decides to “sacrifice” £20,000 of their salary (nearly 17 per cent of their pay) into their company pension scheme (again, we’ll assume a 6 per cent matched contribution).

I fear that cash-strapped employees could be tempted to cut their pension contributions rather than increase them to cope with the rising cost of living

They will be able to save £27,200 into their pension for a cash cost of just £7,350 — pretty much quadrupling their money. In this example, the tax savings from avoiding the levy are £250, and their employer will trim more than £3,000 from the company NI bill.

The second group that really stands to benefit from salary sacrifice are parents who earn between £50,000 and £60,000 per year — the point at which the high income child benefit tax charge kicks in. This threshold hasn’t budged since it was introduced in 2013.

If a worker earning £60,000 sacrificed £10,000 of their salary, they would save £13,600 into their pension for a cash cost of £5,702 and they’d be entitled to keep receiving child benefit worth up to £1,828 per year (assuming they have two children, a partner who also earns less than £50,000 and no other sources of income).

The obvious flaw in these calculations is that not everyone can afford to be tax efficient. The levy makes salary sacrifice more attractive, but I fear that cash-strapped employees could be tempted to cut their pension contributions rather than increase them to cope with the rising cost of living.

If you think salary sacrifice could work for you, consider its inflexibility. Once you have saved money into a pension, you can’t currently get it out again until you’re 55 or older. There is a “window” once a year where you can set or change the percentage of your salary sacrificed. This will then apply every month, unless you have a “life event” (check your HR policy, but typically birth, marriage, divorce or moving house).

If you plan to buy a house or have a baby, be aware that salary sacrifice could affect your level of maternity pay, and crimp the amount that mortgage lenders will let you borrow.

And for higher earners, be aware that the maximum annual allowance for pensions is £40,000 (your contribution, plus the company’s contribution) above which other tax charges will apply.

Finally, next year’s increase will be collected as part of national insurance, but from 2023 the health and social care levy will be a separate line on payslips.

John Endacott, tax partner at PKF, says while it’s expected that the levy will be included in salary sacrifice arrangements, the final rules have yet to be decided. If more companies start using these schemes, there’s always a risk the chancellor could try to limit their uses in future.

However, all the tax experts I spoke to this week were united on one thing — that 1.25 per cent levy can only rise, potentially boosting the benefits of salary sacrifice for those who can afford to use it.

Claer Barrett is the FT’s consumer editor: claer.barrett@ft.com; Twitter @Claerb; Instagram @Claerb