How salary sacrifice works and what it does to your tax

A salary sacrifice arrangement — sometimes called salary packaging — is an agreement between you and your employer under which you receive part of your remuneration as a benefit rather than as salary or wages. The essential feature is that the agreement is made before the salary is earned. This is not a technicality; it is the entire basis on which the arrangement works.

If you agree in advance to forgo a slice of next year's salary, you never derive that income and it is not assessable to you. If you instruct your employer in June to divert the bonus you earned in May, you have simply directed the application of income you already derived, and it is taxed to you in full. The ATO is explicit about this and it is the most common reason an arrangement fails on review.

The arrangement should be documented. There is no prescribed form, but a written agreement stating the amount, the benefit, the period covered and how it can be varied protects both sides. Many employers run packaging through a third-party administrator that produces the paperwork for you.

Your employer is not obliged to offer salary sacrifice. It is a term of your employment, negotiated like any other, and small employers frequently decline because of the administrative cost and the fringe benefits tax exposure. Public sector, university, hospital and not-for-profit employers usually have well-established schemes because their sector attracts concessions.

Salary sacrifice is different from a deduction from your net pay. A deduction happens after tax and gives you no tax benefit at all. If your employer is taking money after tax and calling it packaging, the arrangement is not doing what you think it is. Deductions from pay are also regulated — an employer generally needs your written authorisation and the deduction must be principally for your benefit.

It is also different from claiming a tax deduction yourself. A deduction reduces taxable income when you lodge your return. Salary sacrifice reduces the salary reported to the ATO in the first place. The end result on your tax can be similar; the cash-flow timing and the paperwork are not.

Superannuation. Amounts sacrificed to your super fund are employer contributions. They are not fringe benefits and attract no FBT. Instead they are taxed in the fund as concessional contributions at a flat rate, which for most employees is well below their marginal rate. This is the workhorse of salary packaging and the only version that is worth considering for almost everyone on a middle or higher income.

Fringe benefits. A car, a loan, school fees, private health premiums, entertainment, or an expense your employer pays on your behalf are fringe benefits. The employer pays fringe benefits tax on the grossed-up value at a rate designed to match the top marginal rate plus the Medicare levy. Inside a packaging arrangement the FBT cost is normally passed back to you, so the arrangement only helps if the benefit is concessionally treated, exempt, or if your employer holds an FBT exemption or rebate.

Exempt benefits. Some work-related items carry an FBT exemption when they are primarily for use in your employment — portable electronic devices, protective clothing, tools of trade, briefcases, and certain work-related software and subscriptions. Where an exemption applies you get the item out of pre-tax salary with no FBT and no offsetting cost, which makes this the highest-value category per dollar even though the dollars involved are small. Conditions and item limits apply, and they differ for small business employers, so confirm with the ATO before committing.

Cars are the special case that dominates the market. Under a novated lease the employer takes on your lease obligations and pays the running costs from your pre-tax and post-tax salary. FBT applies, usually calculated under the statutory formula method, and an employee contribution from post-tax salary is commonly used to reduce the taxable value to nil. Whether this beats a conventional car loan depends on the vehicle, the lease term, the interest rate embedded in the lease, the residual value you must pay at the end, and how many kilometres you drive.

There is a significant concession for eligible low and zero-emission vehicles below a value threshold, which removes FBT from those cars and has made electric-vehicle novated leases the most compelling packaging product currently available to ordinary employees. The threshold, the eligible vehicle types and the reporting treatment are set in legislation and have already been narrowed once, so check the current position rather than a two-year-old article.

Not-for-profit and health employers sit outside the normal arithmetic. Public benevolent institutions, health promotion charities, public and not-for-profit hospitals and public ambulance services have capped FBT exemptions, and rebatable employers have a partial rebate. Employees of those organisations can package a capped amount of general living expenses — rent, mortgage payments, groceries — with no FBT, which is materially more valuable than anything available in the private sector. The caps are set in legislation and indexed.

When you sacrifice salary into super, the amount is contributed by your employer and taxed in the fund as a concessional contribution. The saving is the difference between your marginal tax rate plus the Medicare levy and the concessional contributions rate paid by the fund. For a middle-income earner that gap is meaningful; for someone earning under the tax-free threshold it is negative, because you would pay no tax on the salary and the fund will tax the contribution.

Sacrificed amounts count towards your concessional contributions cap together with your employer's compulsory superannuation guarantee contributions and any personal contributions you claim a deduction for. The cap is set annually. Exceeding it means the excess is included in your assessable income, taxed at your marginal rate with an offset for the tax the fund already paid, and an interest charge may apply. This is the single most common way a salary sacrifice arrangement goes wrong.

Because the cap includes compulsory contributions, a pay rise, a bonus, or an employer that pays above the statutory rate can push you over without you changing anything. Anyone sacrificing close to the cap should re-check the arithmetic every time their pay changes, and again after 30 June when the final figures are in.

Unused concessional cap space can be carried forward for a number of years if your total superannuation balance is under a threshold, which lets people with broken work patterns catch up in a single high-income year. This is one of the more useful provisions in the system and one of the least used.

Higher earners face an additional charge on concessional contributions where income plus contributions exceeds a threshold — effectively reducing the concession without eliminating it. Sacrificing is usually still worthwhile above that threshold, but the saving is smaller than the headline suggests.

The obvious limitation is liquidity. Money in super is preserved until you reach preservation age and meet a condition of release. Sacrificing hard in your twenties buys a tax saving in exchange for locking money away for decades, which is a good trade only if you do not need it. Release before then is possible only in narrow circumstances such as severe financial hardship or specified compassionate grounds.

Employers must calculate compulsory superannuation guarantee contributions on your ordinary time earnings including amounts you sacrifice, so sacrificing can no longer be used to reduce an employer's SG obligation. If your employer's contributions fall when you start sacrificing, that is worth querying.

Salary sacrificed super appears on your income statement as a reportable employer superannuation contribution, or RESC. Salary sacrificed fringe benefits above a small threshold appear as a reportable fringe benefits amount, or RFBA, grossed up to a pre-tax equivalent. Neither is taxed again in your hands. Both are added back to your income for a long list of tests.

Those tests include the Medicare levy surcharge, the private health insurance rebate tiers, the compulsory repayment of study and training support loans, family tax benefit, child care subsidy, the low income superannuation tax offset, the seniors and pensioners tax offset, the Commonwealth Seniors Health Card income test and the child support formula. Services Australia calls the combined figure adjusted taxable income and applies it across most family payments.

The practical consequence is that a household near a family tax benefit taper, a child care subsidy step or the Medicare levy surcharge threshold can sacrifice salary, reduce their taxable income, and see no change at all in the outcome that mattered — because the reportable amount put the income straight back. It is not a loophole being closed; it is the system working as designed.

There is one important asymmetry. Reportable amounts are added back for those income tests but are not included in taxable income, so the income tax saving is real even where the entitlement effect is neutral. Salary sacrifice is therefore reliably good for pure tax and unreliable for anything means-tested.

Anyone with a study loan should look carefully. Repayment income for a HELP or VET Student Loan debt includes reportable superannuation contributions and reportable fringe benefits, so sacrificing does not reduce a compulsory repayment. People sacrifice specifically to duck a repayment and are surprised when it appears anyway.

The RFBA gross-up is easy to underestimate. Because it is expressed as the pre-tax salary that would have been needed to buy the benefit, the figure that appears on your income statement is noticeably larger than the value of the benefit you received. Employees of exempt not-for-profit employers commonly see a large reportable amount and assume it is an error.

Work out your marginal tax rate for the coming year, including the Medicare levy, and compare it with the concessional contributions rate. If the gap is small or negative, super sacrifice is not worth doing and you should stop here.

Add your expected compulsory employer contributions to the amount you plan to sacrifice and check the total against the current concessional contributions cap. Leave headroom for a pay rise or bonus. If you have unused cap from previous years and a total super balance under the threshold, check whether carry-forward space is available in ATO online services.

Ask your employer what it actually offers. Many organisations restrict packaging to super plus a short list of exempt items. Others use an external packaging provider with its own fee, which should be deducted from the benefit before you judge the deal.

Get the arrangement in writing before the salary is earned, specifying the amount or percentage, the benefit, the start date and how either side can vary or end it. Confirm whether the sacrifice comes off your gross salary before or after other calculations such as leave loading and overtime.

Check what happens to your other entitlements. Leave accruals, redundancy pay, notice payments, workers compensation and income protection cover are sometimes calculated on your reduced salary rather than your original package. This is a contractual question, not a tax one, and the answer varies by employer.

After the first pay run, check your payslip. Your gross salary should have fallen by the sacrificed amount and the tax withheld should have fallen accordingly. If tax was withheld on the full amount, the arrangement has been set up as a post-tax deduction and needs fixing.

Review at least once a year, and immediately after any pay change. Adjust the sacrifice down if the concessional cap is at risk, and reconsider entirely if your family circumstances now bring means-tested payments into play.

When your income is low. Below the tax-free threshold you pay no income tax on the salary, so sacrificing into super converts untaxed income into contributions taxed in the fund. The government co-contribution and the low income superannuation tax offset exist to address this, and voluntary post-tax contributions are usually the better route for low earners.

When you might need the money. Preservation is absolute in normal circumstances. A deposit, a career break, a business idea or a medical bill cannot be funded from sacrificed super, and hardship release is narrow and slow.

When you are close to the concessional cap already. High employer contributions, a defined benefit interest or an employer paying above the statutory rate can leave very little headroom, and the excess-contributions process is unpleasant.

When the benefit is a car you would not otherwise buy. Novated leasing marketing is aggressive and the arithmetic is dense. Compare the total cost over the lease including the residual payment against buying the same car outright or with a loan, and treat any comparison that omits the residual as incomplete.

When means-tested payments are the point. If the goal is to qualify for a family payment, a card or a rebate tier, reportable amounts will usually defeat it.

When the employer is unstable. Sacrificed super is an employer obligation until it reaches the fund. If the business fails between the pay run and the quarterly contribution deadline, the money is an unsecured debt like unpaid wages. Check that contributions are actually arriving in your fund account rather than assuming they are.