LITRG look at how recent tax, NI and tax credits changes may affect low to middle-income earners taking childcare vouchers from their employers in exchange for a reduction in salary.
Background
For the last few years LITRG have been warning that if you were on a low or middling income and able to recoup most of your childcare costs through tax credits, it would usually be to your disadvantage to start receiving childcare vouchers from your employer in exchange for a reduction in salary. However, from 6 April 2011 the rules change so for some low-income people there may now be a small advantage in taking vouchers. If you accept vouchers, make sure that you understand what is going on.
The previous position
Prior to 6 April 2011, if an employer offered you the opportunity to give up some of your salary in return for receiving some tax-free childcare vouchers, if you were a basic rate (20%) taxpayer also claiming the childcare element of tax credits, it was likely that the correct answer was “no thanks”. The likelihood was that you would lose more in tax credits than you would gain in tax and national insurance savings.
The new rules
From 6 April 2011, the help that you get for childcare costs under the working tax credit rules has been reduced from 80% to 70% of the eligible costs. With this less generous help in tax credits, the savings in tax and national insurance are comparatively greater. Thus more people will be better off accepting vouchers than before. The difficulty is identifying who those people might be.
Is it worth taking childcare vouchers?
Most employers do not give employees childcare vouchers for nothing. Normally an employee is asked to give up salary (subject to tax and national insurance) in exchange for childcare vouchers (free of tax and national insurance up to a certain limit). This is called “salary sacrifice”.
So if your employer asks you after 6 April 2011 whether you would like to take vouchers, before deciding you should get an idea of how much your saving might be. It is unlikely to be large. The basic calculation will probably be like this for some people:
Advantage from reducing salary:
| Increase in tax credits | 41% |
| Reduction in tax | 20% |
| Reduction in national insurance | 12% |
| Total | 73% |
Disadvantage from reducing salary:
| Loss of childcare help in tax credits | 70% |
So in these cases there is a 3% saving if you take the vouchers. As the maximum tax free advantage that can be given under the rules for low-income people is £55 worth of vouchers a week, this translates into £1.65 saving per week.
The figure most likely to vary in this calculation is the extra tax credits you get if you sacrifice part of your salary (up to 41% of the salary you sacrifice). You only get those extra tax credits if your tax credits award is based upon income for the current year in which you make the sacrifice. Most people’s tax credits are based upon previous year’s income, and they will not see that 41% tax credits increase.
Your tax credits award for this tax year, 2011/12, will be based upon your income for last year, 2010/11, if your 2010/11 income is less than or equal to your 2011/12 income. Otherwise, if your 2011/12 income is less than 2010/11, your award will be based on this year’s lower income figure.
Example 1
Assume your income for last year was £14,000 and is £15,000 for this year. If you sacrifice £900 of your income for this year in exchange for vouchers, your tax credit award is still based on £14,000 and you do not receive any 41% benefit. Thus you are likely to be significantly worse off this year.
But when the next tax year comes around, if your tax credits then are based upon income for this year, the year in which you took the sacrifice, you will see the benefit of the 41% extra tax credits.
Example 2
However, if the sacrifice reduces your current year income below £14,000 you will get extra tax credits of 41% of the amount by which your sacrifice takes your income below that figure. You need to understand the value of that, and any tax and NI gains, compared to your loss of childcare help (the 70%).
Everybody’s circumstances will be different and other factors may also need to be taken into account. Next year the figures will change again.
HMRC have updated their better-off voucher calculator so you can check your own situation. No-one who is asked to sacrifice salary and is receiving tax credits should accept vouchers without having used this calculator.
Other things to think about
You should also bear in mind that sacrificing your salary may reduce the value of other benefits provided by an employer, depending upon the rules of the schemes. Any scheme which involves the benefit being based on the actual (rather than notional) salary level of the employee may be affected. For example, the following benefits might be based upon levels of salary:
- Pension benefits
- Death in service benefits
- Accidental death benefits
- Sickness benefits
- Share schemes
- Company redundancy or severance arrangements
- Bonus plans
- Relocation schemes
A good employer should advise an employee of the knock-on effects of salary sacrifice on company benefits when childcare vouchers are proposed. Any employee not receiving this information should ask for it.
Even if employer-provided benefits are not affected, many state benefits are based upon the level of salary and the amounts of national insurance paid by the employee. Some which could be affected by a salary reduction might include:
- Retirement pension
- Contribution-based Jobseekers Allowance
- Contribution-based Employment and Support Allowance
- Statutory redundancy pay
- Statutory maternity, paternity and adoption pay
- Statutory sick pay
Finally, if you are in receipt of means-tested benefits, the effect on those benefits should be considered.
People who pay tax at 40% or higher
In previous years the main people to benefit from childcare vouchers were those with higher incomes and this continues to be the case for those who were getting vouchers prior to 6 April 2011. People who take vouchers for the first time, or – except in limited circumstances – who come out of one scheme and join another, have a much harsher regime in this current tax year, 2011/12, and future years.
Unfortunately the HMRC calculator referred to earlier has not been programmed to show whether someone on a 40% tax rate or above will be better off.
Conclusion
We have never been advocates of low-income people entering into arrangements which they do not understand, and salary sacrifice for childcare vouchers can be extremely complex.
Employers also save money (employers’ national insurance contributions) when employees take vouchers, and voucher companies tend to play down the downsides from taking vouchers, so it may sometimes be difficult to get totally unbiased advice.
But tax credit claimants are obliged always to inform HMRC if they take vouchers, and it is vital that individuals understand what they are doing if they are to avoid tax credit overpayments and penalties.
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