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Buying and selling work holiday: Big tax, pension, mortgage and benefit effects

Paloma Kubiak
Written By:
Paloma Kubiak
Posted:
Updated:
24/02/2023

You may be able to buy and sell holiday to give you more time off or more salary for the exchange. But there could be some major implications, including affecting your income tax band, your maternity pay and pension contributions.

Employees are legally entitled to a minimum 5.6 weeks’ paid annual leave – this includes bank holidays – under the Working Time Regulations 1998.

According to Kate Palmer, HR advice and consultancy director at Peninsula, staff should be encouraged to use all their holiday within the current leave year “and given ample opportunity to do so”.

However, employees can carry over up to 1.6 weeks’ leave into the next holiday year if there is a written agreement, and some companies may offer enhanced holiday entitlement, Palmer says.

This is on top of the statutory minimum and is at the employer’s discretion.

“Some may choose to allow buying and selling of these extra days, others may not. There is no minimum or maximum number of days that an employee can buy and sell, as long as they are given and take their statutory minimum entitlement,” Palmer says.

She adds that when it comes to putting a financial figure on holiday days which are bought or sold, “it is recommended that employees are provided with their normal remuneration”.

From an HR perspective, Palmer says buying or selling holiday wouldn’t have an impact on any other rewards or benefits programmes offered by the firm.

However, from a tax and salary perspective, benefits such as maternity pay, pension contributions and tax relief, and even your mortgage could be impacted by the simple option of buying or selling your annual leave.

The extent depends on what you decide, when and how you will pay back any money owed, such as in advance, over a few months or even over a year.

Matthew Brown, the Chartered Institute of Taxation technical officer, says the underlying arrangement of the holiday scheme “usually determines the tax consequences”.

Selling holiday for more pay

If you’ve accrued additional leave or will have money paid out for holiday entitlement, such as for untaken leave when you move on from the firm, if your leave can’t be carried forward or you simply want to flexibly exchange a certain number of days’ leave for pay, then Brown says the tax consequences here are “straightforward”.

He explains the extra pay constitutes taxable earnings, and as such, will be subject to income tax under PAYE and National Insurance Contribution deductions when paid.

For some workers, this move could actually see them move into a higher tax bracket.

Brown says: “It is worth noting that this extra pay may cause an employee to move from one tax bracket to another, for example by increasing their income so they pass the higher rate tax threshold.”

As an example, if you earn £50,000, you pay the basic (20%) rate of tax. However, if you sold a week’s holiday back to your firm in exchange for an extra £1,000 pay, this could take your earnings into the 40% tax bracket as the threshold income starts at £50,270.

Pensions and benefits

When it comes to the effect on pension contributions, this depends on the terms of the pension scheme and whether it is regarded as pensionable pay, Brown says.

“In a standard auto-enrolment or stakeholder pension arrangement, it is likely to result in additional employee and employer pension contributions. Higher earners will need to check that their pension contributions do not exceed their pensions annual allowance and, in some cases, will need to consider the lifetime allowance too. Another consideration for high earners will be whether the additional pay triggers the annual allowance tapering rules,” he says.

Meanwhile, the effect on statutory benefits will depend on the amount paid and when it is paid.

For statutory maternity pay, the employee needs to be continuously employed for at least 26 weeks by the 15th week (the qualifying week) before the baby is due, while average weekly earnings in the eight weeks before then mustn’t be less than the lower earnings limit for NICs at the end of the qualifying week.

Brown says: “Therefore, swapping holiday leave for pay in the eight weeks prior to the qualifying week could result in an employee qualifying for statutory maternity pay when they otherwise would not. On the other hand, swapping pay for extra ‘unpaid’ holiday during those weeks could result in them failing to qualify for maternity leave.”

Buying holiday in exchange for reduced pay

Brown says this side of the holiday and pay equation is a little more complex as it may depend on whether an employee has access to a flexible benefits plan.

But for simplicity, where an employee is giving up pay for holiday, this ‘salary sacrifice’ which reduces gross pay would mean that PAYE and NICs are applied to the lower amount.

The example below outlines this:

An employee earns £40,000, gains 12% employer pension contributions and has 21 days’ leave but no other benefits-in-kind. In exchange for nine extra days’ leave, the employee will sacrifice £1,500 of salary, meaning they are left with £38,500 cash salary, 12% pension contributions and 30 days’ leave. This would mean the employee would be taxed on £38,500.

Further, Brown says: “If earnings are slightly above a tax threshold then consideration should be given to the net effect of swapping pay for leave,” he says.

“An additional consideration of sacrificing pay for additional leave is that it could result in an employee’s taxable income dropping below tax thresholds, such as the higher rate threshold, the £100,000 threshold at which the personal allowance begins to be tapered away or the additional rate threshold. In some cases it could even take an individual’s income below the personal allowance, while a salary sacrifice that takes earnings below the NIC threshold could have an effect on entitlement to state benefits,” Brown explains.

And for anyone who will be going on maternity leave, Brown explains that swapping pay for additional leave could affect entitlement to statutory maternity pay or other statutory benefits if it means weekly earnings are reduced below the minimum amount for entitlement to these benefits.

“Additionally, where an employer has their own maternity scheme paying above the statutory minimum rates, reducing pay could result in a reduction in the ‘top-up’ they provide.”

Pension tax relief

Meanwhile, when it comes to pension contributions, a fall in earnings could result in less money going into your retirement savings.

Employees should check their contractual agreement to work out whether pension contributions are based on the pre-sacrificed salary or a reduced sacrificed salary.

Using the figures above, that means working out whether the 12% pension contribution would be against the usual £40,000 earnings figure, or the lower £38,500 figure.

Brown says: “Under many salary sacrifice arrangements, the employee’s ‘notional’ pre-sacrificed gross pay is retained as the amount on which pension contributions are accounted for. In fact, the most common salary sacrifice arrangement is swapping pay for additional pension contributions and, usually, part of the agreement is that the pension contributions are based on the pre-sacrificed notional pay.”

One other consideration relating to pension contributions is tax-relief. Higher earners get tax-relief at 40%, while basic rate taxpayers gain 20%.

Brown says: “The main issue to consider with pension contributions would be whether the reduced taxable earnings might affect the maximum tax-relievable pension contributions the employee makes or the marginal rate at which those contributions are tax relieved.

“For example, where an employee is making large personal contributions that are netted off against earnings, could this result in a loss of higher rate tax relief or even take ‘net’ earnings (earnings less allowable pension contributions) below the personal allowance? For high earners, swapping pay for additional leave could mean that they are not subject to the pensions annual allowance tapering rules and potential resulting annual allowance charge.”

Mortgage application

One last consideration with a drop in income is the effect it could have on a prospective mortgage application. One of the tests applied by lenders is the Loan-to-Income (LTI) ratio which refers to how much the mortgage applicant can borrow relative to their annual income. Typically, this stands at 4.5%.

A lower income could therefore impact mortgage borrowing as a lender could treat this as an ongoing commitment reflected in a pay slip.

Calculations by Mike Staton, mortgage and protection advisor at Staton Mortgages, reveal that a £1,000 pay deduction for a holiday could cost a borrower £11,000 in lost affordability.

Based on a £200,000 property, a 25-year mortgage term for a single applicant with two children and an annual income of £40,000, they could borrow £137,000 on a two-year fix.

However, once deducting £1,000 over a year, eg £90 a week, it takes the borrowing down to £126,000.

“That’s an £11,000 drop, a 10% deduction in what a lender will give you, and that’s even before considering any other deductions in life”, Staton says.

He adds: “People think, great yes, I can buy holidays, it’s a really good scheme but they don’t take into account the ramifications.

“People are quite short-sighted, they see the tangible asset of holiday, but six months later, they don’t realise it could mean £10,000 less to buy a property. Where we are based, that’s the difference between a three-bed semi-detached and a two-bed terraced house.”

Staton adds that before exchanging holiday for cash, anyone thinking about buying a property in the next year or two should consider speaking to a mortgage adviser to see the impact it could have on future lending.