Leasing a car could be a salary sacrifice pension pitfall that decimates your pension. Here’s what you can do about it.
(3 minute read)
Today’s top tip will explain:
- What a Salary Sacrifice Agreement is
- How leasing a car can decimate your pension
- How to avoid the tax trap and enjoy more of your pension
Salary Sacrifice Agreements
Salary Sacrifice Agreements are simple in principle. HMRC defines them as ‘agreement[s] to reduce an employee’s entitlement to cash pay, usually in return for a non-cash benefit.’
These agreements are generally used as tax-efficient ways of using your income because the reduction in pay comes before you pay tax on your wage. Effectively, you can pay for an asset tax-free.
To illustrate, this is what your finances may look like without a Salary Sacrifice Agreement:
Receive wage -> Pay tax on whole wage -> Buy asset
But with a salary sacrifice:
Receive reduced wage and non-cash asset -> Pay tax only on remaining wage
It’s very common for employees to lease cars through salary sacrifice. In particular, this is a common way to lease electric cars which may otherwise be too expensive.
However, most people aren’t aware of the detrimental impact leasing a car through this kind of agreement can have on their pensions. You could have a nasty surprise upon retirement if you fall into this tax trap as a result.
How this Tax Trap can Decimate Your Pension
If you have a ‘defined benefit’ pension, the way pension growth is calculated doesn’t fully account for Salary Sacrifice Agreements.
NHS doctors are especially likely to fall into this trap due to the NHS electric car scheme, which uses salary sacrifice.
Let’s say you’re a doctor and you make a £10,000 Salary Sacrifice Agreement to lease a new Tesla. Your pension may not take this £10,000 into account. This means that when your agreement ends and your salary returns to normal, it looks like you’ve received a £10,000 raise.
This can be detrimental to your pension.
This happens because a sudden rise in salary can push you over your annual pension allowance, leading to hefty tax bills.
Tax consultant James Ramshaw calculated that this tax pit fall could leave some with a bill of £28,856.
How to Avoid the Salary Sacrifice Tax Trap
Fortunately, you can avoid the massive tax bill with a little preparation.
Most pensions calculate pay based on the best of the past three years. Therefore, your pension pot will be safe if you end your Salary Sacrifice Agreement after one or two years.
You may also lesson the damage by ending your lease early. Sometimes, the penalty for ending a lease early can be less than the impact on your pension.
If you’re still considering switching to an electric car, there are plenty of other ways to save money on the tax.
As with most things tax, forewarned is forearmed. Understanding the potential pitfalls can help you avoid them, but you may still need help to get the most from your pension.
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