Settlement agreement tax and the £30,000 exemption

The headline number in your settlement agreement is not always what lands in your bank account. Some payments are tax free, some are taxed like salary and some fall in between. Knowing which is which helps you judge an offer properly and spot errors before you sign.

This guide covers the tax side. For the wider picture, start with our guide to settlement agreements explained.

The basic rule: up to £30,000 can be tax free

Payments made because your employment is ending, which you were not already entitled to under your contract, are termination payments under section 401 of the Income Tax (Earnings and Pensions) Act 2003. The first £30,000 is free of income tax. Anything above that is taxed at your marginal rate.

There is no employee National Insurance on these payments. Employers pay employer National Insurance on the amount above £30,000.

The £30,000 is a combined limit. It covers your compensation payment, statutory redundancy pay and any enhanced redundancy pay together, not £30,000 each.

What is always taxed as normal pay

These are earnings, so they go through PAYE with income tax and National Insurance deducted:

• Salary up to your leaving date
• Accrued but untaken holiday pay
• Bonuses and commission you have earned
• Contractual pay in lieu of notice, or pay for working or being on garden leave during notice
• Post employment notice pay (PENP), explained below

Post employment notice pay (PENP)

Since April 2018, employers cannot dodge tax by calling notice pay "compensation". If you do not work your full notice, HMRC requires the employer to work out the basic pay you would have earned during the unworked notice period. That amount, the PENP, is taxed as earnings, even if the agreement labels the whole sum as an ex gratia payment.

Only the part of the termination payment above PENP can benefit from the £30,000 exemption. Our guide to pay in lieu of notice explains the different ways notice can be dealt with.

Worked example

Tom earns £60,000 a year (£5,000 a month) and has a three month notice period. He is placed on immediate leave and offered a £45,000 package with no notice worked.

• PENP: three months' basic pay, £15,000, taxed as earnings with PAYE and National Insurance
• Remaining termination payment: £30,000, entirely tax free
• Total tax free: £30,000

If the package were £55,000 instead, £15,000 would be PENP, £30,000 would be tax free and the remaining £10,000 would be taxed at Tom's marginal rate, but without employee National Insurance.

Legal fees

If your employer pays your legal fees directly to your solicitor as part of a settlement agreement, that payment is not taxed as your income. HMRC treats it as exempt when it is paid to meet the costs of advice on the termination and the agreement provides for it. This is why the fee contribution is usually paid straight to the firm rather than to you.

Pension contributions

Some or all of a payment above £30,000 can sometimes be paid into your pension by your employer instead of to you. Employer contributions to a registered pension scheme are not taxed as your income, subject to your annual allowance. This can save a lot of tax for higher earners, but it has to be agreed and written into the agreement before payment. Ask your solicitor to check your allowance first.

Injury to feelings and discrimination payments

Compensation for injury to feelings connected with the termination is generally treated as part of the termination payment, so it counts towards the £30,000 rather than being separately exempt. Payments for a genuine psychiatric or physical injury can be treated differently. This area is technical, so if a discrimination element is significant, get specific tax advice.

The tax indemnity clause

Almost every agreement includes a clause saying you will repay your employer if HMRC later decides more tax was due. That makes it your risk if the tax treatment is wrong. Make sure your solicitor checks how each payment is described and taxed, and push for the employer to deduct tax correctly at source.

Five checks before you sign

1. Is notice pay separated out and PENP calculated correctly?

2. Has statutory redundancy pay been counted within the £30,000?

3. Is holiday pay listed separately and taxed?

4. Are legal fees paid directly to your solicitor?

5. Would pension contributions save you tax on any excess?

A clear tax breakdown is also useful leverage when you are negotiating a settlement agreement, because asking for a payment to be structured efficiently can add real value at little cost to the employer.

Get the numbers checked

A settlement that looks generous can lose thousands to tax if it is structured badly. Match My Solicitor connects you with employment solicitors who check the figures and the tax treatment as part of their advice, usually funded by your employer's contribution. Get matched with a solicitor today.