The basic rule
Tax follows the reason for the payment. Money you earned or were contractually entitled to is earnings. Money paid because your employment is ending, which you had no contractual right to, is a termination payment, and the first £30,000 of that is exempt.
| Payment | Income tax | Your National Insurance |
|---|---|---|
| Salary to the leaving date | Taxed | Yes |
| Holiday pay | Taxed | Yes |
| Bonus and commission | Taxed | Yes |
| Notice pay, worked, garden leave or in lieu | Taxed | Yes |
| Payment for new restrictive covenants | Taxed | Yes |
| Statutory redundancy pay | Tax-free within the £30,000 | No |
| Enhanced redundancy and compensation for loss of employment | Tax-free within the £30,000, taxed above | No |
| Legal fees paid direct to your solicitor | Tax-free | No |
| Employer contribution to your registered pension | Tax-free within your annual allowance | No |
How the £30,000 exemption works
The exemption applies once per termination. Statutory redundancy pay, any enhanced redundancy pay and any compensation are added together, and the first £30,000 of the total is exempt. Payments from associated employers for the same termination share one allowance. If the money is paid in instalments across two tax years, the exemption is used against the earliest payments first.
Non-cash benefits that continue after you leave, such as a company car or medical cover, also count towards the £30,000 at their taxable value.
Notice pay and PENP
Since 6 April 2018 employers must work out "post-employment notice pay", or PENP. In simple terms it is the basic pay you would have earned during any notice you did not work. That amount is taxed as earnings and attracts National Insurance, even if your contract has no pay in lieu clause and even if the agreement describes the whole payment as compensation.
Example. Dan earns £5,000 a month and is entitled to three months' notice. He leaves immediately with a single payment of £40,000 described as compensation. His PENP is £15,000, which is taxed as earnings. The other £25,000 is a termination payment and falls within the £30,000 exemption, so it is tax-free.
See notice pay and PILON for the detail.
Above £30,000
The excess is taxed at your marginal rate. Because it arrives as a lump sum, part of it may fall into a higher band than your salary normally reaches. You pay no employee National Insurance on it. Your employer pays Class 1A National Insurance at 15% on the excess, which is a real cost to them and is one reason employers like to keep termination payments at or under £30,000.
Ways to make a payment more tax-efficient
- Pension. Your employer can pay part of the termination payment straight into your registered pension scheme. It is not taxed and does not use up the £30,000, provided you stay within your annual allowance (£60,000 for most people, less for very high earners).
- Legal fees. A contribution paid by your employer direct to your solicitor, under the settlement agreement, for advice about the termination only, is exempt.
- Timing. If you will earn less next tax year, a termination date after 5 April can mean the taxable part is taxed at a lower rate.
- Injury and disability. A payment made because you can no longer do your job owing to injury or disability can be fully exempt. HMRC applies this narrowly and it needs medical evidence. See sickness and ill health.
None of these work by relabelling. HMRC looks at what a payment is really for.
Payments after your P45
If the taxable part is paid after your P45 has been issued, your employer must use tax code 0T. That gives no personal allowance and applies the basic, higher and additional rates in monthly slices, so too much tax is often deducted. You can reclaim it from HMRC. Asking for payment through the final payroll before the P45 avoids the problem.
The tax indemnity
Nearly every agreement says that if HMRC later decides more tax is due, you will pay it and reimburse your employer. That is normal. Ask for the indemnity to exclude penalties and interest caused by the employer's delay, and for the employer to tell you about any HMRC demand before paying it so you can challenge it. See the clauses explained.
Frequently asked questions
Is the first £30,000 of a settlement always tax-free?
No. Only genuine compensation for the termination qualifies. Anything you were contractually entitled to, such as notice pay, holiday pay or a bonus, is taxed as earnings.
Do I pay National Insurance on a settlement payment?
Not on the termination payment itself, whatever its size. You do pay it on notice pay, holiday pay and bonus. Your employer pays Class 1A National Insurance at 15% on termination payments above £30,000.
I was taxed too much on my settlement. Can I get it back?
Often, yes. If the payment was made after your P45, the taxable part is taxed on a 0T code with no personal allowance. You can claim a refund from HMRC during the tax year or through self-assessment.
Is injury to feelings compensation taxable?
If it relates to discrimination during your employment and not to the termination, it can be paid tax-free and does not use the £30,000. If it is connected to the termination, it counts towards the £30,000.
Sources
About this guide. This page is general information, not legal advice, and reflects the law and published government plans on the date shown above. Frederick George is a legal referral service, not a law firm. For advice on your own circumstances we will introduce you to an SRA-regulated solicitor.