How to save tax on bonuses in the UK
Are you earning more than £50,270 per year? Do you want to reduce your tax bill?
You might want to consider bonus sacrifice.
What is bonus sacrifice?
Bonus sacrifice is where you pay your bonus into your pension instead of having it paid into your bank account. By doing this, you can save a significant amount of tax and build wealth for your future.
If you have already received your bonus, it’s not too late. You can still pay into your pension and reduce your tax bill.
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)
This article will show you how putting your bonus into your pension can save you tax and how Ian generated an almost 300% return on his investment.
1. How are bonuses taxed in the UK?
Clients often ask me:
- Are bonuses taxed?
- Can I avoid paying tax on my bonus?
- Can I reduce tax on my bonus?
To all of the above, the answer is yes! Bonuses are taxed in the same way as your salary. It’s added on top of your salary to determine how much tax you pay on your bonus.
If you take your bonus as cash, you will pay income tax and insurance at your marginal rate of tax.
The below summarises how much tax you will pay on your bonus. Your bonus is added on top of your salary to determine how much tax you pay. Assume that you earn £50,270 and receive a bonus of £10,000; you will pay income tax at 40% and national insurance at 2%. Generally speaking, the more you earn, the more tax you will pay.
The primary way to avoid paying tax is to sacrifice your bonus into your pension.
If you have a student loan, you will also pay a portion of your bonus as a deduction.
Likewise, if you have children and receive child benefit, you may pay a tax charge if your bonus results in your total income exceeding £50,270.
2. What’s the benefit of bonus sacrifice?
People often ask me: “how to avoid paying tax on bonuses in the UK?” The most straightforward/simplest answer is to sacrifice your bonus into your pension. By doing this, you avoid paying tax and national insurance on your bonus. You also avoid paying a student loan and child benefit tax charges, if these apply to you.
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 between 2% and 12% (note, national insurance will increase by a further 1.25% from 2022/23 tax year). By sacrificing your bonus into a pension, you avoid paying tax on your bonus.
Let’s assume that you earn £50,270 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 National insurance Contribution (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 instead you pay the £10,000 bonus into a pension, you avoid paying tax altogether. The full £10,000 will be paid into your pension.
Effectively, you’ve turned £5,800 into £10,000 . Or, if you have kids, you’ve turned £4,012 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).
The tax-saving benefits are even greater if you earn above £100,000 (or if the bonus pushes your total earnings above this). This is because your Personal Allowance (the first £12,570 of income you can earn tax-free) is reduced when you earn above £100,000. For every £2 you earn above £100,000, you lose £1 of your Personal Allowance.
So once your earnings reach £125,140, you lose all your £12,570 tax-free Personal Allowance allowance. This means that you effectively pay tax at 60% on earnings between £100,000 – £125,140; this is also known as the 60% tax trap.
By allocating your bonus to your pension, you can regain your personal allowance and save even more tax.
3. 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!
It’s important to remember that each tax year will be different depending on your total income, including bonuses and any RSUs or Stock Awards. You may not know the complete picture until the end of the tax year.
Every person is restricted to how much they can put into a pension. Typically, 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. Depending on your earnings, your pension allowance can be reduced down to £4,000. If you have high earnings, there are various things you can do to avoid the tapered annual allowance – check out this article on how to avoid the tapered pension 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.
4. How does bonus sacrifice work in practice?
It’s relatively 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 wish 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!
5. How Ian made a nearly 300% return by paying his bonus pension
Ian works in central Reading for Microsoft. He earns a salary of £110,000 per year and pays 5% of this into a pension. He has just been awarded a bonus of £20,000.
He is a higher rate taxpayer, and he is also hit by the 60% tax trap (where his income above £100,000 is taxed at 60%).
He has decided to sacrifice his entire bonus of £20,000 into his pension. His employer will pay this figure into his pension scheme and has agreed to add the employer NIC savings on top.
Without bonus sacrifice:
If Ian took the bonus as cash, he would pay:
- Income tax of £12,000 (60%).
- National insurance of £400 (2%)
- Student loan of £1,800 (9%)
This means that Ian pays a total of £14,200 in taxes on his £20,000 bonus, equivalent to losing 71%.
After taxes/deductions, Ian receives just £5,800 of his £20,000 bonus.
With bonus sacrifice:
By sacrificing the total bonus into his pension, he will pay no tax on this. Also, his employer has agreed to pay their National Insurance savings into this pension. This gives Ian an additional £2,760 (13.80%).
So in total, Ian would have £22,760 in his pension.
That’s £16,960 more than if he took the bonus in cash.
That’s almost a 300% return (292% to be exact).
Want to save tax and make your money work harder for you? Schedule an initial consultation with one of our tax planning experts today.
As part of your initial financial consultation, we will help you understand your current financial position, offer useful suggestions for how to improve your finances and discuss how we can help you with your financial planning. We’ll also discuss our services
6. 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 because you never get taxed on the income you do not receive.
This is different to making regular personal pension contributions and workplace pension contributions. This is because regular pension contributions are paid from after taxed income. By sacrificing your bonus before it is received, you benefit from higher tax savings than you would by paying your bonus into your pension after it has been received as cash.
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!).
Let’s assume that you earn £80,000 and receive a bonus of £10,000.
- With bonus sacrifice, you never receive the bonus and it goes straight into the pension. You give up £10,000 in exchange for £10,000 into your pension.
- With average pension contributions, you pay £4,200 in income tax/NI, leaving you with £5,800. If you then contribute this to a pension, the Government will add £1,450 giving a total pension contribution of £7,250. You can also claim a tax rebate for £1,450, giving a total ‘benefit’ of £8,700.
Obviously, £8,700 is less than £10,000, and that’s why bonus sacrifice is more tax efficient.
7. What to watch out for
Now, before you go ploughing all your money into a pension, there are a few things you need to watch out for.
The Government knows that pensions are a good deal; it costs them a fortune to provide pension 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 significant pension contribution:
1. Annual allowance
The maximum that can 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 three 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 an 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.
2. Lifetime allowance
This annual allowance limits how much you can pay; the lifetime allowance controls how much the pension can be worth.
If your pension exceeds the ‘lifetime allowance’, currently £1,073,100, 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.
3. Minimum pension age
Any money paid into a pension is not accessible until you reach 55. This is the minimum pension age; you have to be 55 before you can withdraw money from your pension.
Over time, the Government is increasing this age, linking the minimum pension age to ten years before the 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.
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.
4. Pension availability
If you have a workplace pension and want to sacrifice your bonus, your employer may require you to pay into your workplace pension. If so, you can give up part of your salary, which your employer pays into your pensions along with their contribution.
5. Employee benefits
The impact of your bonus reduction will be felt in other aspects of your life.
For example, by reducing your bonus, you are technically decreasing 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 minimise other employee benefits.
8. How can we help?
As independent financial advisers, we can advise you on the best ways to save tax. We provide a full review of your financial situation and create a strategy that helps you save taxes, make smart decisions with all aspects of your finances and avoid making expensive mistakes. Learn more about:
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.
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