This is part 2 of my “How to save NI with pension contributions” series.
In part 1 (Tax hack: How to save NI with pension contributions – Lazy Fi Dad), I told you about a cool trick you could (potentially) use to save on National Insurance (NI) just by changing the timings of your pension contributions. For example, instead of contributing 30% of your gross salary to pension, just by doing 10% one month and 50% the following month, you could save NI. Yes, you contribute the same total amount to your pension over the two months, but you pay less NI. If you have no idea what I’m on about, please read part 1. I will assume you did and move on. Anyway, I made a mistake.
Despite some doubts from some of you, this method worked for me. However, I did get one thing wrong and it cost me hundreds of pounds. As you know, when pursuing FI, every penny counts. You can imagine how annoying it was to find out that not only did I lose hundreds of pounds, it was due to something I misunderstood, 100% my fault, arghhhhhh!
Before I can explain exactly what happened, I have to explain how employers treat your pension contributions and where it appears in your payslip.
Salary sacrifice vs Deduction
There are two ways your employer can treat your pension contributions. It can either be a deduction or a salary sacrifice.
If your pension contributions are treated as a deduction, it is taken from your salary AFTER tax. If this is how your employer treats pensions, part 1 is completely irrelevant for you, sorry. You can’t save NI here, you will pay NI (and income tax) on your full gross income and only then, your employer will transfer money to your pension provider.
The way this works is they assume you are a basic tax rate payer. As the basic tax rate is 20%, your pension contribution will be grossed up, let me explain. Let’s say you contribute £480 of your salary to your pension, the assumption is that you pay 20% income tax so, to earn that £480, you would have had to earn a gross salary of £600 (600*80%=480). To fix that, you get a tax benefit of £120 or 25% (120/600).
If you are a higher rate tax rate payer, things get more difficult. First of all, you pay 40% tax, so to contribute £480, you would have to earn £800 (800*60%=480). You’re probably thinking “OK, they’ll top me up £320, wrong. They will still top up your pension by £120 and to get the extra £200, you’ll have to submit a self-assessment to HMRC, a hassle (which I will not have to do).
For additional rate tax rate payers, it’s the same concept as the higher tax rate payers but with 45% instead of 40%.
Please notice that the gross-up (whether direct or through self-assessment) is purely for income tax, there are no NI savings due to pension contributions here at all.
If your employer treats your pension contributions as a deduction, you will usually see the pension contributions below the tax deduction in your payslip.
This is a much nicer way to contribute to your pension. Here, your pension contributions are taken BEFORE taxes. That means that if you are a higher rate tax payer (for example), your taxable pay is deducted by the amount you contribute and saves you 42% (!) in tax (40% income tax + 2% NI). I love this way because:
- It saves NI as well
- No need for self-assessments
If your employer treats your pension contributions as a salary sacrifice, you will usually see the pension contributions above the tax deduction in your payslip.
My mistake while trying to save NI
Until my last paycheck, all of my pension contributions were salary sacrifices. This one wasn’t, for two reasons:
The first reason is that I got some paternity pay. I took two weeks off work after my son was born, this did not come out of my holiday allowance. Apparently, this automatically moves me from salary sacrifice to deduction. Good to know for the future but if that was the only reason, I wouldn’t be writing this post.
The second reason is that I went below the National Minimum Wage (NMW). John Kash warned me about this in the comments section of part 1. The annoying part is that despite listening to him (he was right), I still went under, just because I didn’t understand how it was calculated!
Before I go into how the NMW criterion is calculated, I would like to explain what this mistake cost me (/us). It not only cost us the NI on all of my pension contributions (which was big), but it also cost me the fee I’ll have to pay my accountant to submit my self-assessment.
While this is (very) annoying, I can’t help my fascination with this whole thing. Anyway, I’m here to talk numbers again and hopefully help you to avoid making a similar mistake.
How is the NMW criterion calculated?
The NMW rate is £9.50 an hour for anyone over 23 (for the 22/23 tax year, ending on April 2023. Despite my infantile sense of humour, I am over 23. £9.50 is the NMW rate for me. For other rates, or if you just don’t want to take my word for it, visit this GOV.UK page.
As usual, let me run you through an example, based on a true story (although the numbers are made up).
Meet Confused Lazy FI Person, he works 160 hours a month and earns £60,000 per annum, which is £5,000 a month.
Confused Lazy FI Person wants to save NI and calculates the minimum amount which he can’t go under. He types £9.50*160 into his calculator (or Excel) and sees the number £1,520 as the result. Confused Lazy FI Person thinks he can contribute £3,480 (5,000 – 1,520), sounds reasonable. £3,480 represents 69.6% of his gross salary. As his employer makes him choose full percentage point, he goes with 69%, which is £3,450. Now let’s look at 2 different scenarios.
Scenario 1- no leave
In this scenario, Confused Lazy FI Person (wow, that’s a long name) took no time off work. He got the numbers spot on and will be able to contribute £3,450 into his pension as a salary sacrifice.
He worked 160 hours and got paid £1,550 (5,000 – 3,450). If we divide £1,550 by 160 hours, we get an hourly rate of £9.6875, that’s over £9.50, so no issue.
Scenario 2- 40 hours of leave
Here is where things get interesting. When you take leave, the whole calculation gets f***ed up. Don’t worry, there are 2 brand new calculators at the bottom of this post. Before that, let’s look at scenario 2.
In this scenario, we have the same numbers but this time, Confused Lazy FI Person took 40 hours of leave. I initially thought the calculation in scenario 1 would apply. I was wrong.
Let’s see how the NMW threshold is calculated.
First, they take your gross pay and divide it by your total (work + holiday/leave) hours to calculate an hourly rate. Confused Lazy FI Person earns £5,000 for 160 hours, so £31.25 per hour.
The next stage is to calculate how much you earned on the hours you actually worked. Out of the 160 hours, he only worked 120, so he earned £31.25*120 = £3,750. You can also calculate it as £5000 * 120 / 160 as you worked 120 out of 160 hours.
The final and oh-so-annoying stage is deducting your pension contributions….. only from the hours you worked! let’s calculate:
Confused Lazy FI Person worked 120 hours, earned £3,750 for those hours, and contributed £3,450 to his pension. That leaves him with £300 for 120 hours, which is £2.50 per hour (£300/120). As you can already guess, £2.50 an hour is way below the NMW and will result in the pension contribution being treated as a deduction and not a salary sacrifice. If it didn’t, his employer would be breaking the law by paying less than NMW. Poor old Confused Lazy FI Person (definitely too long), will now have to pay NI on the full £3,750 and, potentially, fill in a self-assessment with HMRC.
In the calculator below (the first one), you can see that even 2 hours of leave would have taken him below NMW.
To sum this up, they attribute ALL of your pension contributions only to the hours you actually worked (excluding time off). I assume this is the same with all employers but I’m not sure, this is how my employers calculates it.
The conclusion from trying to save NI
First, I didn’t go into “is this calculation fair?”. I don’t really care to be honest. I have no will to change the rules, I’m here to understand the rules (this time I didn’t) and play by them.
Second, While I did consider NMW, I did not fully understand how to calculate the NMW threshold. Now that I do (until my next lesson), I will be more careful. It was an expensive lesson but an interesting one nonetheless.
If the numbers confuse you- have no fear, Lazy FI Dad is here (this should be a bumper sticker). I have created two small Excel calculators just for you, have fun!
- You can only change the yellow cells.
- Once you update a cell, the calculator may take a couple of seconds to update.
- The final answer is in the green cells.
- You can download a copy of these calculators to your computer or use them straight here. To enter a number, just double-click the cell you want to change.
- If you want to improve your Excel skills without installing Excel, you can practice Excel online at Excel Practice Online (I get nothing if you go there by the way).
I started with Confused Lazy FI Person’s numbers but feel free to change them to your own numbers.
Trying to save NI- calculators
The first calculator calculates the maximum number of hours you can take as leave during a pay period without going below the NMW given a specific pension contribution rate:
You can see that Confused Lazy FI Person could not even take 2 hours of leave without going below the NMW (or reducing his pension contribution).
The second calculator calculates the maximum pension contribution % in during a pay period without going below the NMW given a specific number of leave hours:
Here, you can see that Confused Lazy FI Person could have still taken the 40 hours of leave but he would have had to reduce his pension contribution to 52% (or less). That way, his pension contribution would have still been treated as a salary sacrifice.
I hope my story doesn’t deter you from trying to save money on taxes and I also hope you will learn from my mistake and not repeat it.
Oh, and in case you’re wondering- the method from part 1 will still save me money this tax year, even after the costs of this specific paycheck 🙂
Now that I know how the NMW threshold is calculated, I will adjust my pension contributions accordingly for each pay period. I will book my leave as normal and then calculate how much I can contribute. I don’t believe in letting pension contributions determine when you take time off work. I’ll be using the second calculator.
That means I can use the method from part 1 but I will contribute more in months when I don’t have many days off. In months when I do have lots of time off, that’s when I will reduce my pension contributions.
I’ll keep you updated on any new lessons I learn along the way. I hope the next lessons will be less expensive.
Thanks for the this article. Does this apply to all white collar workers? Only that “hours” isn’t on my payslip. I’m paid in “periods”, and there are 12 periods in a month. I’m also doing this NI method, and judging from this article perhaps this unfortunate outcome is only for workers that are billed by the hour, rather than people (who I assumed was almost everyone) who are paid on a monthly basis, regardless of their annual leave / sick days / whatever else.
I am not an hourly paid employee, which was why I was so surprised by this! I get paid every 4 weeks, the same £ amount each time and the same amount of hours.
My payslip still shows hours and is split between leave/holiday and work for each payslip.
My experience may be unique to my employer but I thought it was worth sharing.
How has this method been working for you?
Presumably you would have the same issue if you went off sick, and you wouldn’t be able to predict that in advance.
You only have to do self assessment, or potentially just write or ring HMRC, to gain higher rate tax relief if your employers use “relief at source” for their deduction method. If its “net pay” which is common then they take the pension before tax. Anyway you should find out and should be able to work that out from whats gone into your pension online.
Correct, which is why a small buffer would be useful. For example, if I calculate the maximum contribution (without going below NMW) as 60%, maybe I’d do 55% or something like that?
This isn’t really an issue for me, personally. When I’m sick, I just let my manager know, I don’t usually log it in the system anyway, just holiday/leave.
I’m really surprised at this – if you are on paid annual leave it shouldn’t matter how many hours you worked in that period if your salary is quoted annually and paid monthly. Perhaps the situation was unique as you were on statutory paternity leave and it doesn’t apply to usual annual leave? I’ve never seen it treated this way for normal leave. Did your accountant agree with this treatment? Thanks for the knowledge and excel! Super helpful.
A colleague and I both tried this method, my colleague wasn’t on paternity leave and still had the exact same issue.
I confirmed this with our payroll team, ask yours and let’s see if it’s just my employer 🙂
buh149/LazyFiDad, this all depends on your contract. Please see this article on HMRC’s website for more details:
In particular the section ‘absences from work’ under ‘salaried hours work’ (as you both appear to be talking about this type of work) which states:
“If you pay a salaried worker their normal salary while they are absent from work and this forms a part of their employment contract, the time of the absence counts towards the worker’s time worked for minimum wage purposes. For example, during rest breaks, lunch breaks, holidays, sickness absence or maternity / paternity / adoption leave.
If you have not included pay for these absences as part of the worker’s basic hours under their employment contract (that is, if they are not covered by the annual salary), you do not have to take the hours of absence into account for minimum wage purposes.”
In my experience the latter is quite unusual though and most contracts would cover paid absences and therefore the calculations in this post would not be necessary.
I am too afraid to test this out DJ haha.
As I said, I got “fined” (no salary sacrifce and therefore, no NI savings at all) for 2 reasons at the same month:
1. I took some paternity leave, which automatically took me out of salary sacrifice for that month
2. A colleague of mine got the same result without going on maternity leave, just by contributing too much and ignoring her time off.
Reason number 2 makes this experiment too risky, but I might send her this link in case she wants to challenge it! Thanks, it was a very interesting read.
It certainly sounds as though your contracts are of the latter variety that HMRC talks about if your colleague fell foul of going under minimum wage. So definitely something people need to be aware of. Love the blog by the way, very informative.
So lets say you accumulate a lot of leave and then take a full month off. Would that mean you are not even able to contribute 0.1% into salary sacrifice that month?
Based on this, the 160 hours would be paid the full rate of your salary and any pension contribution would come out of the 0 hours your worked?
Or just assume you work 1hour/1day in a month if the above is not making sense.
It’s a really good question (!), I love extreme scenarios as it tests our understanding. I’m not sure what the answer is, to be honest. However, I’ve never had so many days taken off in one month.
What I would do (not advice):
For that month, if I didn’t known the outcome in advance,I would probably max the employer match but nothing else/more.
Just to clarify, it’s not that you can’t contribute to your pension, it’s just that it won’t be a salary sacrifice. It would come from your net, not gross. You would still get your income tax back but no NI saving.
I hope that makes sense, let me know if anything was unclear
Yes I agree with you that the safest course is to only contribute upto employer matching.
I agree you can still contribute to pension but this post is all about NI savings using salary sacrifice.
By the way for the month you messed up, did you also lose out on the employer matching?