Colin Dyer, Client Director at abrdn, explores some key considerations around bonus sacrifice - what is it, and what are its advantages?
For some in the legal profession, the coming months will bring a boost to pay packets in the form of a Spring bonus. Individuals may be thinking hard about how to best spend the money. As part of this process, it will be valuable to consider how they can use these funds to best support their long-term financial goals.
One option will be to invest in retirement savings. For those who know that they will get a bonus, but are yet to actually receive it, using a ‘bonus sacrifice’ will be a powerful way to help grow their pension pot while saving tax and adding some extra money to their retirement funds through the process. Here we explore some of the key considerations around bonus sacrifice – what is it, what are the advantages and what do lawyers need to keep in mind?
What is a bonus sacrifice?
A bonus sacrifice — sometimes referred to as a ‘bonus exchange’ — involves an agreement between an employee of a law firm and their employer to give up some of a bonus that they are yet to receive in return for a non-cash benefit from their employer – for example, an employer pension contribution.
The rules around non-discretionary bonuses (those not linked contractually guaranteed, for example for meeting defined performance targets) and discretionary bonuses (those that employers may give out on an ad hoc basis) are slightly different, and something lawyers and employers will need to address.
A discretionary bonus does not need to be formally documented – an employer can simply pay the amount into a pension as a contribution. However, a valid bonus sacrifice of a non-discretionary bonus needs to be documented through a change to an employee’s terms and conditions of employment. Employers are not obliged to offer bonus sacrifices, but some will do as part of their wider benefits package.
Note that if a lawyer is self-employed, as some partners will be, they will not be eligible to use a salary sacrifice arrangement, although they can offer it to their employees.
How does it work, and what are its advantages?
The primary advantage of using a bonus sacrifice is saving tax. If an individual receives a discretionary bonus in cash, that money would be liable for income tax and National Insurance (NI) at their marginal rate – ultimately eroding the amount of money that would end up in their pocket. By way of illustration, a £10,000 discretionary bonus paid to an employed lawyer who was a higher rate taxpayer in England earning a base annual salary of £80,000 would result in a ‘take home’ value of £5,800 once income tax and NI had been deducted. However, if a bonus is ‘sacrificed’ directly into a pension plan, neither tax nor NI will be payable. As a result, the full £10,000 will be added to their pension pot – maximising the bonus’ ultimate value.
This process can offer advantages to law firms too. Because employers usually pay NI on all earnings above the earnings threshold, they’ll normally save 13.8% of the amount that they would otherwise pay an employee directly.
Often, employers are even willing to share part of this NI saving with their employees – in some cases ultimately boosting the amount that an individual ultimately receives in their pension plan beyond the size of the original bonus. An employer willing to pass on their NI savings of a £10,000 bonus sacrifice into their employee’s pension would add a further £1,380 to the pension contribution. So the extra £5,800 a higher rate tax paying employee would have had in their hand as a bonus is worth £11,380 in their pension at no extra cost to the employer.
Reviewing options, seeking advice
Despite the advantages, it’s important to note that a bonus sacrifice won’t be right for everyone and every circumstance. They will also need to make sure that the pension contribution their employer makes doesn’t breach their standard tax-free pension annual allowance of £40,000 – or a lower value if they are subject to the tapered annual allowance.
Understanding processes like bonus sacrifice can be time-consuming and complex, but speaking to a professional can help an individual assess whether it's right for them and navigate the process. The right support will help ensure that lawyers are maximising opportunities to make the most of their money now, in service of their future goals.
