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 on 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.

Deduction

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 to 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.

Salary sacrifice

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:

1. It saves NI as well
2. 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?

Update 11/06/2023: While I use £9.50 as the National Minimum Wage (NMW) below, the NMW from 06/04/2023 is £10.42, not £9.50.

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).

Examples’ background

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 employer 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!

As usual:

1. You can only change the yellow cells.
2. Once you update a cell, the calculator may take a couple of seconds to update.
3. The final answer is in the green cells.
4. 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.
5. 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 🙂

Next steps

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.