There are three methods of applying tax relief to pension contributions.
Salary sacrifice
Net pay arrangement
Relief at source
This article explains the differences between each type.
Salary Sacrifice
Salary sacrifice is the method of reducing gross pay by the amount of the pension contribution, which in turn reduces the pay on which you calculate:
Tax
Employee and employer national insurance
Salary sacrifice is a tax-efficient and cost-effective way of deducting both employee and employer pension contributions.
When setting up a salary sacrifice scheme, it's important to remember that:
Employees must agree to enter in to a salary sacrifice arrangement, as they effectively reduce their gross pay.
Salary sacrifice reduces gross pay, which means that an employee’s eligibility for things such as statutory sick and statutory maternity pay may be impacted.
National minimum wage is calculated on post-sacrifice earnings. It is not permissible to reduce an employee to below the minimum wage because of their salary sacrifice deductions.
Net Pay Arrangement
Processing pension deductions through a net pay arrangement is where pension deductions are taken before the tax calculation, lowering gross taxable pay.
This arrangement doesn't provide a National Insurance saving for the employee or employer.
Considerations for net pay arrangement:
Relief is given at the rate of tax the employee pays.
As a result, no relief is available if an employee doesn't pay tax.
Relief at Source
Relief at source is the process where pension deductions are taken from net pay after the deduction of tax.
80% of the employee's pension deduction will be taken via the employee's pay, and the remaining 20% will be automatically reclaimed by the pension provider which is then added in to an employee’s pension pot.
The 20% tax relief will still be given if the employee has not paid tax in the tax year due to their earnings falling below the annual threshold.
Considerations for operating relief at source
The month-to-month cost is higher for an employee and employer as deductions are taken after the calculation of tax and National Insurance.
The annual saving is still lower than a salary sacrifice arrangement as there is no National Insurance relief.
Relief is paid straight into an employee’s pension, unlike salary sacrifice arrangements.
Employees in higher tax brackets need to reclaim any additional tax relief via self-assessment.
Impact of each tax relief arrangement
The following table shows the net impact to the employee and employer based on each of the three arrangements:
