This post is going to be super-niche. It will be completely irrelevant for most of you. For the few of you that this is relevant for, you can save £100s off your NI (National insurance) payments with very little effort. I’m going to explain how you can save a big chunk of your NI payments using your pension contributions (but not increasing them).
Who is this relevant for?
This is only relevant for you if you:
- Earn more than £4,189 a month/ £50,268 a year gross (before tax)
- Have an employer that allows you to easily change your pension contributions each month
- Have a pension that is “salary sacrifice”
I attended the Financial independence London Meetup*. The meetup itself was interesting but when it ended, some people stayed on to chat. One of those people was Duane. Duane is a fellow FI pursuer and a fellow mystery diner.
Duane shared with us an awesome hack he found to save money on NI with pension contributions. I’ll do my best to explain how it works, the advantages, and the disadvantages.
I am almost embarrassed to admit how excited I was to find out about this.
Before we go any further, we need a disclaimer:
I am not a tax adviser and don’t know your personal situation. This content is not tax advice and should not be treated as tax advice. Please do your own research and/or use a tax professional before acting.
How NI is calculated
I don’t know if you know that but Income tax is calculated annually. That means that if you had a high salary for 6 months and was then unemployed for 6 months, you’ll probably get money back as you paid higher tax while employed. That’s because while you were employed, it was assumed you’ll earn that amount each month for a full year (12 months). When the tax year ends, HMRC looks at how much you earned for the year and recalculates your tax, this could result in a refund or an additional charge.
National insurance is a different story. It is calculated for each pay period, this can be weekly, monthly, or annually.
The downside of this calculation method is you will not get a refund if you’re unemployed for part of the year. Your allowance or calculation resets after each paycheck you get.
The upside of this calculation method is that we can use this periodic reset to save some big money. We can do this by timing our pension contributions, I’ll explain the mechanics shortly. I can’t believe I never thought of that and that this is not common knowledge, thanks Duane for pointing this out!
Assuming you get paid monthly:
The first £797 you earn each month are exempt from national insurance.
Anything you earn between £797 and £4,189 each month is taxed at 12% (NI only, income tax is separate).
Anything above £4,189 a month is taxed at 2% (Again- NI only, income tax is separate).
Example 1- £72k a year, no bonus (flat pension contribution rate)
Let’s get to know Lazy FI person 1:
- Lazy FI person 1 earns £72k a year (£6k a month) and has no bonus.
- His employer offers a pension contribution match of up to 5%. Lazy FI person 1 knows employer matches are awesome and will always contribute at least 5% of his base salary to his pension.
- Lazy FI person is a dad and wants to get his taxable salary down to £50k to get the full child benefit.
He does some quick maths and realizes he needs to contribute £22k a year to his pension. He calculates a contribution rate of 31% (22/72 rounded up).
Here is how his NI calculation looks like:
How to read this
The Uk tax year starts on April 6th each year and ends on April 5th the following year. That’s why my months are from April until March.
The first line is the base salary.
The second line is the bonus (no bonus in this example)
Then we have the Total (base salary + bonus)
The pension contributions were calculated above at 31% to get us under £50k annual.
This sums to a monthly contribution of £1,860 but more importantly- £22,320 a year. This figure will be important in example 2.
Once you deduct the pension contributions from the Total (third line) you get your taxable salary. We see £49,680, just under £50k.
The next section shows the split of each salary into the NI tax rates.
Then we see a breakdown (and total) of the NI charge. Total NI- £4,814.
Important things to notice in example 1
Notice how £40.1k out of the £49.7k is taxed at 12%? we’re going to fix that.
Also, remember his gross salary (£72k), his total pension contributions (£22,320), and his total NI charge (£4,814). Let’s see how we can reduce that.
Example 2- £72k a year, no bonus (custom contribution rate)
Same details as before but this time, Lazy FI person 1 tries to save NI with pension contributions. He will still contribute the same amount annually but will spread it out differently.
Lazy FI person 1 will not reduce his taxable income below £797 a month. He wants to utilise his NI exempt amount.
On the other hand, he will also not contribute less than 5%, he does not want to lose his employer match.
Lazy FI person 1 does some quick maths again. He notices that to get to £797 (in a specific month), he needs to contribute 86% (1 – 797/6000, rounded down so we don’t lose NI exempt money).
He contributes 86% for the first 3 months (April-June) and 5% for the last 8 months (August-March). That leaves him with 74% in the fourth month (July) in order to have the same contributions as in example 1.
Here is how his NI calculation looks like:
Important things to notice in example 2
In this example, Lazy FI person 1’s gross salary (£72k) and pension contributions (£22,320) are the same as in example 1.
Remember how £40.1k out of the £49.7k was taxed at 12% in example 1? Look at him now. He moved £12.1k to the 2% rate.
Look at the total NI charge! it’s down from £4,814 to £3,605! That’s a saving of £1,209!
You can see where the £1,209 comes from. We transferred £12,088 from a 12% rate to a 2% rate, saving 10%.
£12,088 * 10% = £1,209 (rounded to the nearest pound).
Look how much he was able to save on NI with pension contributions, my mind is blown.
I feel like NI handed me an amazing tax hack!
Example 3- £60k a year, 12k bonus (flat contribution rate)
Let’s get to know Lazy FI person 2:
- Lazy FI person 2 earns a base salary of £60k a year (£5k a month) and gets a £12k bonus once a year, in December.
- His employer also offers a pension contribution match of up to 5%. Lazy FI person 2 also knows employer matches are awesome and will always contribute at least 5% of his base salary to his pension.
- Lazy FI person is also a dad (shocking, I know) and he also wants to get his taxable salary down to £50k to get the full child benefit.
He also does some quick maths and realizes he needs to contribute £22k a year to his pension. He calculates a contribution rate of 37% (22/60 rounded up). This assumes the pension contributions are calculated on the base salary only.
Here is how his NI calculation looks like:
Important things to notice in example 3
Because of the bonus in December, Lazy FI person 2 has one month with a big salary. A big chunk of it (£11k) is charged at 2%, that’s good! That’s why his total NI charge (£3,732) is lower than Lazy FI person’s NI charge in example 1 (£4,814).
Also, remember his gross salary (£72k), his total pension contributions (£22,200), and his total NI charge (£3,732). Let’s see how we can reduce that.
Example 4- £60k a year, 12k bonus (custom contribution rate, the right way)
Same details as in example 3 but this time, Lazy FI person 2 tries to save NI with pension contributions. He will still contribute the same amount annually but will spread it out differently. He does it the right way (we will see in example 5 what the wrong way is).
Just like Lazy FI person 1, Lazy FI person 2 will also not reduce his taxable income below £797 a month. He also wants to utilise his NI exempt amount.
On the other hand, he will also not contribute less than 5%, he does not want to lose his employer match. Just like Lazy FI person 1.
Lazy FI person 2 also does some quick maths again. He notices that to get to £797 in a specific month, he needs to contribute 84% (1 – 797/5000, rounded down so we don’t lose NI exempt money).
He contributes 84% for the first 4 months (April- July) and 5% for the last 7 months (September-March). That leaves him with 73% in the fifth month (August) in order to have the same contributions as in example 1.
Here is how his NI calculation looks like:
Important things to notice in example 4
In this example, Lazy FI person 2’s gross salary (£72k) and pension contributions (£22,200) are the same as in example 3.
Remember how “only” £10,961 out of the £49,800k was taxed at 2% in example 3? Lazy FI person managed to increase that to £15,927. That’s an additional £4,966, not bad!
Look at the total NI charge, it’s down from £3,732 to £3,236. That’s a saving of £496!
Just like in example 2, the £496 is the 10% saving (from 12% to 2%) on the £4,966 he moved to the 2% bracket.
The savings in this example (£496) is smaller than in example 2 (£1,209) because there is a high salary (December, due to the bonus) which already had a chunk in the 2% bracket, even in example 3, where Lazy FI person 3 used a flat rate.
In April-August in the table above we have £3 each month taxed at 12%, the “NI at 12% row” shows zero due to rounding.
Example 5- £60k a year, 12k bonus (custom contribution rate, the wrong way)
OK, one more example.
Lazy FI person 2 understood how moving the majority of pension contributions to fewer months can save him money. However, he tried to be too smart for his own good. He thought to himself:
“I know I’m getting a huge salary in December, I don’t need all that money. Let me contribute 84% in that month (instead of 5%) and in return, I’ll lower July’s contributions from 84% to 5%”
Let’s see what happens:
Important things to notice in example 5
How come his total NI charge go from £3,236 to £3,575? That’s an extra charge of £339!
The reason we save NI with pension contributions is that we want some months to have the highest taxable salary possible. That way, we get a bigger percentage of our salary taxed at 2% rather than at 12%. Lazy FI person 2 had one big salary in the year, that’s exactly the month to leave it to be as high as possible! contribute the minimum to max the employer match, that’s it.
This is my favourite example because that’s what I planned to do when I first heard about this “hack”. I’m so happy I ran the numbers, could’ve cost me a few £100s.
Save NI with pension contributions – Summary
Using these 5 examples, we showed that save NI with pension contributions. All we have to do is move from a flat percentage to a variable (custom) percentage.
We also saw that in the highest paying months- we should contribute the least to our pensions.
Things to consider before you save NI with pension contributions
- I frontloaded the pension to contribution for simplicity, you don’t have to. You can move the months around as long as you don’t increase the pension contributions in the months with the highest gross salary. For example, in example 2 we did 3 months of 84%, one month of 74%, followed by 8 months of 5%. You can do one month of 84% then 2 months of 5% and repeat this for 3 quarters. In the final quarter, have one month of 74% followed by 2 months of 5%. You’ll get the exact same result.
- This method means you will have a few months with a higher net (after-tax) pay and a few months with lower net pay. If this fluctuation makes you feel uneasy, you don’t have to use this method, that’s fine. It requires some cashflow planning and isn’t for everyone.
- Want to play around with the numbers? Be my guest, here is the file I made while trying to get my head around this concept. I included 5 tabs, one for each example. You can access the file by clicking here. I restricted the access to view only (for obvious reasons). If you want to change the numbers, feel free to download a copy to your computer.
Your circumstances and tax considerations
- If you are about to apply for a loan/mortgage soon, having a few salaries with a low net pay may affect your loan/mortgage. In that case, delay the higher contributions to after you get accepted for the loan/mortgage.
- If you are a high earner, the pension contribution limits (currently £40k a year with some caveats) may make things a bit harder for you.
- In order to implement this method, you must earn more than £4,189 a month/ £50,268 a year. Otherwise, you don’t reach the 2% (soon to be 3.25%, see below) bracket.
- From tax year 22/23 (starting April 6th 2023), the NI rates will increase by 1.25%. 12% will change to 13.25% and 2% will change to 3.25%. This method should work exactly the same, you will still save 10% on any amount transferred to the lower rate bracket. However, the total charge will be higher due to this increase. You can read about the increase in this GOV.UK page. You can also see the rates and brackets on that page.
- This method might mess your tax code a bit. However, as I mentioned in the beginning, if you are overcharged, you’ll get refunded by HMRC. You can also get an extra charge so please do your own calculations and/or use a tax professional.
- My employer allows me to change my contribution percentage with a click of a mouse button. Some employers don’t. Some employers force you to choose your percentage once a year. My old employer allowed me to change it but I had to ask payroll to do it each time. They would hate my guts! Is the relationship with the payroll team worth more or less than the amount saved? That’s for you to decide.
* This happens almost every month, feel free to join:
Link to the meetup page
One final note:
I only found out about this on Tuesday (16/11/2021). This post is a result of my journey to understand this concept. If I got anything wrong, please let me know by commenting on this post. We are all here to learn 🙂
As John Kash mentioned in the comments, I missed something in the examples above. There is a limit on how low you can get your net salary.
Based on the GOV.UK guidance:
“A salary sacrifice arrangement must not reduce an employee’s cash earnings below the National Minimum Wage (NMW) rates. Employers must put procedures in place to cap salary sacrifice deduction and ensure NMW rates are maintained.”
How much is the National minimum wage?
The current (21/22) rate is £8.91 an hour, going up to £9.50 in 22/23 (see the rates here) for people aged 23 or over.
That means that if your contracted hours are 35 hours a week (most office jobs from my understanding), that’s £311.85 a week (35 * £8.91), going up to £332.50 a week (35 * £9.50) from 22/23. If we multiply this by 52 we get to £16,216.20 a year, going up to £17,290. The final step is dividing by 12 to get the monthly NMW:
£1,351.35 in 21/22, going up to £1,440.83 from 22/23.
Apparently, you can not get your net salary below that amount using salary sacrifice.
I may have missed a few pounds here or there, happy to be correct.
Thanks again John for pointing this out, I love it when readers teach me new things.
Important update number 2
I misunderstood how the NMW threshold is calculated and it cost me hundreds of pounds. Please read this post to avoid making the same mistake: