Bonus sacrifice – how to save tax
If there’s one question I hear more than any other, it’s “how much tax will I pay on my bonus?”, closely followed by “how can I avoid tax on my bonus?”.
If you’re a high earner, the answer to “how much tax will I pay on my bonus” is normally “a lot!”. If you want to run the numbers, check out this bonus tax calculator UK.
Fortunately, there’s a way to reduce how much tax you will pay on your bonus with bonus sacrifice.
Bonus sacrifice is the act of paying your bonus into your pension instead of having it paid into your bank account. By doing this, you can make huge tax savings whilst building wealth for your future.
If you have already received your bonus, it’s not too late. You can still pay a lump sum into your pension to reduce your tax bill.
If you’re earning more than £50,000 per year, and want to reduce your tax bill, then read on!
This article will show you how putting your bonus in your pension can save tax, and how Ian generated a 200% return on his investment.
How are bonuses taxed?
Your bonus is taxed the same way as your salary – i.e. you pay income tax and national insurance, assuming you take it as cash. This is summarised below.
0% income tax on the first £12,500 of salary/bonus (£0 – £12,500)
20% income tax and 12% NI on the next £37,500 of salary/bonus (£12,500 – £50,000)
40% income tax and 2% NI on the next £100,000 of salary/bonus (£50,000 – £150,000)
45% income tax and 2% NI on any additional salary/bonus (£150,000+)
Your bonus is added on top of your salary to determine how much tax you pay. Assume that you earn £50,000, and receive a bonus of £10,000, you will pay income tax at 40% and national insurance at 2%.
What is bonus sacrifice?
If you’re a high earner, the chances are that your bonus makes up a significant part of your overall remuneration.
Typically, you’ll be able to sacrifice some, or all of your bonus into your pension. This is known as bonus sacrifice (aka salary sacrifice or salary exchange)
What’s the benefit of bonus sacrifice?
Bonus sacrifice gives an immediate tax saving.
Depending on your earnings, it’s likely that some or all of your bonus will be taxed at 40% or 45%. You will also pay National Insurance of between 2% and 12%.
By sacrificing your bonus into a pension, not only do you avoid paying tax, you get tax relief!
Let’s assume that you earn £50,000 and receive a bonus of £10,000.
If you receive the £10,000 bonus in cash, you’ll pay £4,000 in tax and £200 in NIC, leaving you with only £5,800. You’ll also pay another £1,788 in child tax charges if you have kids, leaving you with only £4,012 (aka the £50k child benefit trap).
If you pay the £10,000 bonus into a pension, you don’t pay any tax at all – you get to keep the full £10,000.
Effectively, you’ve turned £5,800 (or £4,012 if you have kids) into £10,000!
What’s more, your employer won’t pay any NIC (usually 13.8%) if the bonus is paid into the pension. In many cases, employers will pass this saving on to you, which in the case above would be an additional £1,380 (£11,380).
There are even greater benefits if you earn above £100,000 (or if the bonus pushes your total earnings above this).
This is because your Personal Allowance (the tax-free amount of income you can earn) gets reduced. For every £2 you earn above £100,000, you lose £1 of your Personal Allowance.
So once your earnings reach £125,000, you lose all your £12,500 tax-free Personal Allowance allowance. This means that you effectively pay tax at 60% on earnings between £100,000 – £125,000.
By allocating your bonus to your pension, you can regain your personal allowance save even more tax.
Bonus sacrifice for high earners
If you’re a high earner, the tax savings on offer can be considerable. But you need to be careful with the Tapered Annual Allowance. Get it wrong and you could be faced with a big tax bill!
Every person is restricted to how much they can put into a pension. Normally, this is either 100% of your earnings or £40,000 (whichever is less). But if you’re a high earner, earning above £200,000, you might be affected by the tapered annual allowance.
This will limit how much you can put into a pension, sometimes right down to £4,000 per annum. If you have high earnings, there are three things you can do to avoid the tapered annual allowance.
“How much can I put into a pension?” is a simple question, but there’s no easy answer. It requires you to work out your annual allowance and the impact of any tapered allowance. There’s a balance between maximising the tax breaks without paying any tax charges.
If you need help working out your annual allowance, feel free to drop me a line.
How does bonus sacrifice work in practice?
It’s fairly simple:
- Your employer notifies you of your upcoming bonus
- You work out how much you want to (and how much you should) sacrifice into a pension
- You let your employer know how much of your bonus you want to sacrifice into a pension
- Your employer pays some or all of your bonus into your pension scheme
- Tax relief (aka free money) is applied automatically – you don’t need to do anything!
How Ian made a 200% return by paying his bonus into his pension
Ian works in central Bristol for a Technology company. He earns a salary of £110,000 per year, pays 5% of this into a pension and has just been awarded a bonus of £20,000.
He is a higher rate taxpayer and he is also hit by the rules for people earning over £100,000 who have their personal allowance removed (i.e. he is in the tax trap).
He has decided to sacrifice his entire bonus of £20,000. His employer will pay this figure into his pension scheme in March and has agreed to add the employer NIC savings on top.
Without bonus sacrifice:
If Ian took the bonus as cash, he would pay 40% tax on the bonus, and would also lose his Personal Allowance (another 20%). He would also pay National Insurance at 2% (£400). In effect, he would pay tax and NI of 62%!
So in total, he would pay £12,400 of tax and NIC on the £20,000 bonus, leaving him with just £7,600.
With bonus sacrifice:
By sacrificing the full bonus into his pension, he will pay no tax on this. Also, his employer has agreed to pay their saved National Insurance (13.8%) into the pension – £2,760.
So in total, Ian would have £22,760 in his pension.
That’s £15,160 more than if he took the bonus in cash.
That’s nearly a 200% increase (199.47% increase to be exact).
How is bonus sacrifice different from standard pension contributions?
Bonus sacrifice is one of the most tax-efficient ways of saving money for the future.
It is tax-efficient since you never get taxed on the income you do not receive.
If we compare this to the normal personal pension contributions, these are made from your post-tax income. This means that you pay Income Tax and National Insurance at the standard rates. You then get 20% tax relief at source into your pension, plus 20-25% additionally via your tax return later if you pay income tax at 40% or 45%.
Bonus sacrifice benefits you immediately and you also save National Insurance (yours and potentially your employers too!).
If you pay into an occupational pension scheme, this is paid in via the net pay arrangement, which is different from the rules for personal pensions. You will still benefit from savings to National Insurance.
Our article on pension tax relief explains more about how this works with standard pension contributions.
Things to watch out for:
Now, before you go ploughing all your money into a pension, there are a few landmines you need to watch out for.
The Government knows that pensions are a good deal. It costs them a fortune to provide tax relief, which is why they limit how much you can put in.
The below summarises the key things you should be thinking about before making a large pension contribution:
The maximum allowed to be paid into your pension plan is £40,000 in one tax year. This includes your employee and employer contributions.
You can use pension carry forward to use up unused allowances for the previous 3 tax years. In theory, you can contribute up to £160,000 into a pension by using this method.
If you’re a high earner with income greater than £200,000, you need to be careful. Check out our article on the tapered annual allowance for high earners, which reduces your pension allowances if you earn over £240,000. You could pay additional tax if you use bonus sacrifice, which would negate the benefits highlighted in this article.
Whereas this annual allowance deals with how much you can pay in, the lifetime allowance deals with how much the pension can be worth.
If your pension exceeds the ‘lifetime allowance’, currently £1,055,000, then you may pay a lifetime allowance charge.
Fortunately, there are ways to mitigate the lifetime allowance charge, for example, you can register for lifetime allowance protection. But even with protection, there’s no guarantee that you won’t pay a lifetime allowance charge.
For more information, check out the five easy ways to avoid the lifetime allowance.
Minimum pension age
Any money paid into a pension is not accessible until you reach 55. This is the minimum pension age, i.e. the age you can withdraw money from your pension.
Over time, the Government is increasing this age, linking the minimum pension age to ten years before State Pension age. This means that you may not be able to access the pension until 57 or 58, depending on what age you receive the State Pension.
Obviously, if you’re going to sacrifice your bonus into a pension, you need to be sure that you won’t need the money until then.
You may have a pension through your workplace and your own private pension. If you want to sacrifice your bonus then your employer may require you to pay into your workplace pension.
The fact that your bonus is reduced could impact you in other ways. For example, by reducing your bonus you are technically reducing your income, which could reduce the amount you’re able to borrow (e.g. mortgage).
Equally, some of your other employee benefits might be calculated based on your total income (such as sick pay or life cover). By reducing your bonus, you may reduce other employee benefits.
Free Tax Planning Review
Bonus sacrifice is just one of the many ways you can reduce your tax bill.
If you’re looking to save tax, why not book in for a free tax planning review?
We’ll look at your financial position and provide you with practical steps you can take to reduce your tax bill.
All the best,
James Mackay, Independent Financial Adviser in Bristol
P.s bonus sacrifice is just one way to save tax. There are another 10 ways to reduce your tax bill.
Financial Advisor Bristol and Pension Advisor Clifton
About us: Frazer James Financial Advisers is a financial advisor, based in Clifton, Bristol. As an independent financial adviser, we’re able to provide independent and unbiased financial advice. We provide independent financial advice, pension advice, investment advice, inheritance tax planning and insurance advice.
Frazer James Financial Advisers is located at Square Works, 17 – 18 Berkeley Square, Bristol, BS8 1HB.
This article provides information about investing, but not personal advice. If you’re not sure which investments are right for you, please request advice.
Remember that investments can go up and down in value, you may get back less than you put in.