What Is a Salary Sacrifice Scheme & How Does It Work?

A salary sacrifice scheme represents a financial arrangement between an employer and an employee, enabling the employee to give up a portion of their gross salary. In exchange for this reduction, the employer provides a non-cash benefit of a similar value. This mechanism is designed to create efficiencies, primarily leading to potential savings on income tax and social security contributions for both parties involved. The core principle involves reallocating a part of an employee’s pre-tax earnings towards specific benefits. This strategic approach can make certain benefits more accessible and affordable.

Understanding Salary Sacrifice

Salary sacrifice, also known as salary packaging or salary exchange, is fundamentally a contractual agreement. Under this arrangement, an employee agrees to a formal amendment of their employment contract, reducing their gross pay. In return, the employer commits to providing a non-cash benefit, which is then paid for directly by the employer. The significance of this reduction occurring from gross pay is central to the financial advantages it offers.

Because the salary reduction happens before taxes and social security contributions are calculated, the employee’s taxable income is effectively lowered. Employers also benefit, as their social security contributions, which are typically calculated based on an employee’s gross earnings, may also decrease. The employer then covers the cost of the chosen benefit, which is often more cost-effective than if the employee purchased the same benefit with their post-tax income.

How Salary Sacrifice Works

A salary sacrifice arrangement begins with a mutual agreement between the employee and employer. The employee formally agrees to amend their employment contract, reducing their gross salary by an amount equivalent to the cost of the desired non-cash benefit. This revised lower gross salary then becomes the basis for calculating income tax and social security contributions.

Employers also realize savings. Employers typically pay a percentage of their employees’ gross salaries towards social security contributions. By reducing the gross salary through a sacrifice arrangement, the employer’s corresponding social security contribution liability on that portion of the salary is also lowered. The employer may then choose to pass on some or all of their social security savings back to the employee, often by enhancing the non-cash benefit or adding to a pension contribution.

To illustrate, consider an employee earning a gross monthly salary of $3,000. If they opt to sacrifice $200 for a non-cash benefit, their new gross monthly salary becomes $2,800. Assuming an illustrative income tax rate of 20% and social security contribution rate of 12% for the employee, and an employer social security contribution rate of 13.8%:

Before Sacrifice:
Income Tax: $3,000 20% = $600
Employee Social Security: $3,000 12% = $360
Employer Social Security: $200 13.8% = $27.60 (on the sacrificed amount)

After Sacrifice:
New Taxable Gross Salary: $2,800
Income Tax: $2,800 20% = $560
Employee Social Security: $2,800 12% = $336

In this example, the employee saves $40 on income tax ($600 – $560) and $24 on social security ($360 – $336), totaling $64 in monthly savings. The employer also saves $27.60 per month in social security contributions on the $200 sacrificed amount.

Common Applications of Salary Sacrifice

Salary sacrifice schemes are commonly applied to various non-cash benefits, offering financial advantages to employees. One of the most frequent applications is for pension contributions. Instead of employees making contributions from their after-tax income, a portion of their gross salary is sacrificed, and the employer then contributes this amount directly to the employee’s pension fund. This method allows both the employee and employer to save on social security contributions on the sacrificed amount, effectively increasing the net contribution to the pension.

Another prevalent scheme is the “Cycle to Work” initiative, which enables employees to obtain bicycles and cycling accessories. Through salary sacrifice, the cost of the bike is deducted from the employee’s gross pay over a period, typically 12 to 24 months. The employer purchases the equipment upfront, and the employee essentially leases it, with an option to purchase it at a reduced value at the end of the term. This makes cycling to work more accessible and affordable.

Electric car schemes have also emerged as a popular application of salary sacrifice. Employees can lease an electric vehicle by sacrificing a portion of their gross salary, which covers the monthly lease payments. This arrangement results in significant savings on income tax and social security contributions, making electric vehicles more financially attractive. These schemes often include maintenance, servicing, and sometimes even insurance within the single monthly payment, further enhancing the benefit.

Childcare vouchers were historically a widespread use of salary sacrifice, allowing parents to pay for registered childcare from their pre-tax salary. These schemes enabled savings on income tax and social security contributions for childcare expenses, providing financial relief for working parents.