Salary Sacrifice: What Can Be Included in an Arrangement?

General Principles of Salary Sacrifice

Salary sacrifice, also known as salary packaging or salary exchange, is a formal agreement between an employee and their employer. This arrangement allows an employee to forgo a portion of their future salary or wages in exchange for non-cash benefits of a similar value. The core concept is that the employee’s gross taxable income is reduced, as the sacrificed amount is used by the employer to provide the agreed-upon benefits.

For a salary sacrifice arrangement to be considered valid for tax purposes, certain conditions must be met. The agreement must be established and documented in writing before the employee earns the income being sacrificed, applying to future earnings, not salary already earned. The benefit itself must be provided by the employer, rather than the employee purchasing an item and then seeking reimbursement.

The employer must incur the expense for the benefit, which is typically a non-cash item or service. This can also potentially reduce the employer’s payroll tax obligations, such as Social Security and Medicare taxes, on the portion of salary that is sacrificed.

Common Items Included in Salary Sacrifice

Many common benefits can be included in a salary sacrifice arrangement in exchange for valuable non-cash perks. The eligibility of specific items often depends on their classification under Internal Revenue Service (IRS) guidelines as qualified fringe benefits, which are generally excluded from an employee’s gross income.

One widely utilized option is pre-tax contributions to retirement plans, such as a 401(k) or 403(b). Employees can contribute a portion of their gross pay to these accounts before federal income taxes are calculated. This strategy allows retirement savings to grow tax-deferred, with taxes typically paid only upon withdrawal during retirement.

Health insurance premiums are frequently paid through pre-tax deductions. If an employer offers a Section 125 Cafeteria Plan, employees can pay for health, dental, and vision insurance premiums with pre-tax dollars. Contributions to Health Savings Accounts (HSAs) for those enrolled in high-deductible health plans also offer a triple tax advantage where contributions, earnings, and qualified withdrawals are tax-free. Flexible Spending Accounts (FSAs) for medical expenses also allow pre-tax contributions.

Dependent care assistance is another common benefit that can be salary sacrificed through a Dependent Care Flexible Spending Account (DCFSA). Employees can set aside pre-tax dollars, up to an annual limit, to pay for eligible dependent care services like daycare, preschool, or after-school programs for children under 13, or care for a disabled spouse or dependent, potentially saving a significant percentage on dependent care costs.

Employer-provided educational assistance can also be structured as a non-taxable benefit. Under Section 127, employers can provide up to $5,250 annually in tax-free reimbursements for educational expenses, including tuition, fees, books, and student loan payments. Expenses for education that maintains or improves skills for an employee’s current job may be treated as a working condition fringe benefit under Section 132, with no annual limit on tax-free reimbursement.

Certain work-related expenses can also qualify as non-taxable fringe benefits. This includes items like mobile phones, laptops, and other technology equipment, provided they are primarily used for business purposes. Commuter benefits, such as transit passes or qualified parking costs, can be deducted from an employee’s pay on a pre-tax basis.

Items Not Typically Included in Salary Sacrifice

While salary sacrifice arrangements offer various benefits, not all expenses or forms of compensation can be included. The IRS generally considers any employer-provided benefit taxable unless a specific exclusion applies. Items not explicitly designated as non-taxable fringe benefits or those not meeting specific IRS criteria are typically not eligible for salary sacrifice.

Cash payments or direct reimbursements for personal expenses are generally not permitted. If an employer provides cash or a cash equivalent, such as gift cards, it is almost always considered taxable income to the employee. The intent of salary sacrifice is to exchange salary for a non-cash benefit, not to provide tax-free cash.

Personal living expenses not primarily for work-related purposes or qualifying as a specific fringe benefit are typically excluded. This includes everyday costs like groceries, personal utility bills, or credit card debts. Such expenses are considered personal consumption and do not fall under tax-advantaged employer-provided benefits. Loan repayments are generally not eligible unless structured as a specific, qualified fringe benefit.

Benefits perceived as a substitute for an employee’s salary without meeting non-taxable fringe benefit criteria are unlikely to be included. The arrangement must clearly involve a non-cash benefit where the employer incurs the expense. Items not meeting the “otherwise deductible” rule, meaning they would not be deductible by the employee if paid directly, are also typically not eligible for tax-advantaged salary sacrifice.

How Salary Sacrifice Affects Your Financials

Engaging in a salary sacrifice arrangement directly impacts an individual’s financial situation. By converting a portion of salary into pre-tax benefits, an employee’s gross taxable income is reduced, leading to a lower federal income tax liability as income tax is calculated on the reduced gross amount.

Although taxable income decreases, immediate take-home pay will also be lower. The sacrificed portion of salary is diverted to cover the cost of chosen benefits. However, the value of non-cash benefits received can often offset this reduction, especially if they are items the employee would have purchased with after-tax dollars.

Contributing to retirement savings through pre-tax salary sacrifice, such as a 401(k), can significantly enhance long-term financial security. These contributions allow funds to grow tax-deferred until retirement, potentially at a lower tax rate than current income, leading to a larger retirement nest egg compared to making after-tax contributions.

Some salary-sacrificed items may be subject to fringe benefits tax (FBT), generally the employer’s responsibility. Most fringe benefits are taxable unless specifically excluded by law. While the employer typically pays FBT, its cost can sometimes be factored into the overall salary package, indirectly affecting the employee’s total compensation.

A reduced gross salary due to salary sacrifice could also influence eligibility for certain income-tested benefits or loan applications. For example, some social security benefits or mortgage eligibility calculations might consider gross income. Individuals should assess how a lower reported income might affect such areas before entering a salary sacrifice agreement.