Company pension contributions and ISA money

Salary sacrifice schemes are great. Basically you take a lower taxable and NI'able salary and they put the cash gross into a pension instead. If you are at the level where you pay 12%NI then that's a very good saving. If you are at a higher salary where you only pay 2%NI it is less of a gain but still better than nothing. On the tax side, 20% tax is a good thing to avoid and if you are at a higher salary the 40% is even better.

So, if you give up £800 that was part of your salary, you don't give up £800 net pay because you would have paid £160 tax (or an even higher percentage in a higher tax band) and you would have paid some NI on it too(although less in a higher band). Your net pay doesn't drop by as much as £800 so you won't need to take as much as £800 out of your S&S ISA to make up the shortfall.

Effectively you will be moving this [less than £800] out of your S&S ISA into your pension to access when you are older.

BUT - remember that the money you had in the S&S ISA had already been taxed. Although you get £800 into your pension now, and it costs you less than £800 of your taxed income, because you're saving tax here and now - you will probably pay tax at some rate in retirement when you take it out. You need to understand how this works because if you are thinking it makes sense to borrow to invest even more in this when you run out of S&S ISA, the 'free money' is perhaps not as much as you think.

Example, you have £640 in an ISA which you already funded out of your taxed income. Over the years to retirement the investment returns means it quadruples to £2560 and this is yours to keep tax free because there is no tax on money taken out of an ISA. Alternatively you fund a pension with £800. Over the years to retirement it quadruples to £3200. When you are old enough you take out the £3200 as additional income, and pay your 20% tax on it, leaving the exact same £2560. If the 20% rate doesn't fall, it is not a free lunch.

So, you think you are getting a great deal but this may not be the case. In the above example it didn't give you a boost. It all comes down to what effective tax rate do you pay on the £3200 in retirement, which hopefully is lower than 20%.

In retirement, you can (currently) take a 'tax free lump sum' from the pension of a quarter of the pot, so only £2400 of the £3200 is taxable at your marginal rate. And if your state pension and the rest of your employer pensions and the rest of your personal pensions are not enough to go over the annual personal allowance in the year you draw out this £2400, some of it might be entirely tax free. Certainly it could be handy to take some of it out if you give up work before 'normal' retirement age and don't have employment income or state pension income or much other income; maybe all of the £2400 would escape tax.

But a lot of people would just end up paying their normal 20% tax on the £2400 after taking their standard tax free lump sum. This would mean they pay £480 tax. So out of the £3200 they pay £480 tax which is an effective tax rate of 15% and means they have £2720 in their hand. Clearly this is better than having the £2560 in their hand from the ISA, because saving tax at 20% now and paying 15% later is a good thing. But if they don't get to use the money efficiently at really really low tax rates, the value is not as good as it would be for some people.

This is just looking at the tax element of the savings. Basically there is a benefit, and it's worth doing, but you pay for that in loss of flexibility because you can't take it out of the scheme until you're old enough, whereas you can take your S&S ISA money out whenever you like. If you are happy with that, and it sounds like you are, then that's great. But just don't blindly assume the £800 is all tax free just like the £640 in the ISA today is tax free. The £800 that you avoid paying tax on today is still taxable later, after the special tax-free lump sum, so you'll need to plan carefully to minimise your tax on that money in retirement.

The real boost with a 'salary sacrifice' scheme is your NI saving. The NI that you save today is not going to be payable in retirement, because when you get paid your £3200 it is not wages or salaries and you only pay income tax and not NI.

As an aside, by reducing your taxable and NIable salary, the company also saves cash because employers pay NI on their payroll just like employees do. That is one of the reasons it can be worth their while taking the time/expense to offer the schemes; sometimes they will even share their own NI savings with you and give you even more of a boost to what they pay in.

fifeken wrote: »

In fact, once my savings are gone, it might even make sense to borrow money to do it, as long as loan interest is less than tax saved (assuming I want to keep putting extra into the pension).

But as above you do have to work it through all the way to the end to see what tax you save. In the example above, after taking out a 25% tax-free lump sum and getting net £2720 in retirement, it was not a massive amount more than just getting the £2560 from the ISA. Looks like about 6% more money. So if you borrowed money for a few years to help fund it and incurred interest charges, you're eating into that gain.

That maths was excluding your healthy NI savings so the gains can be really quite substantial, but borrowing money to make more pension contributions than you can really afford, just like borrowing money to make other types of investments, is quite risky, and if the money you borrowed is stuck in a pension scheme that can't be accessed for decades, you could get yourself into a mess. I don't want to dwell on that and take this thread off topic because there was another thread in the last couple of days on it.

In summary - yes salary sacrifice pensions are useful and any pension plan (personal or workplace) has an advantage over ISAs because you will get the opportunity to defer tax now and permanently avoid a bit of tax (tax free lump sum) and maybe avoid a lot more tax (depending on your marginal rates when you take the money out in retirement). And if your pension is a salary sacrifice version, the extra NI permanently saved is great. The cost of doing that is a loss of flexibility because your S&S ISA or other savings can be cashed in tomorrow and your pension cannot.