Settlement agreement tax: the £30,000 exemption, notice pay and legal fees

Under a settlement agreement, genuine compensation for losing your job is usually free of income tax up to £30,000. Anything your employer would owe you anyway, such as salary, holiday pay, contractual bonus and pay for notice you do not work, is taxed as normal earnings. Your employer's contribution to your legal fees is not taxable if it is paid directly to your solicitor under the agreement.

This guide gives the general position in the UK. It is not tax advice. If your package includes shares, large pension contributions or payments abroad, you may need specialist tax advice.

The £30,000 exemption

Section 403 of the Income Tax (Earnings and Pensions) Act 2003 provides that payments made in connection with the termination of your employment are taxable only to the extent they exceed £30,000. It applies to payments you are not otherwise entitled to under your contract, such as:

• an ex gratia or compensation payment for the loss of your job; and
• statutory redundancy pay, which counts towards the £30,000.

Anything above £30,000 is taxed as income. Above that level, employers also pay Class 1A National Insurance on the excess. Employees do not usually pay National Insurance on the exempt compensation.

What is taxed as normal

• Salary up to your leaving date.
• Holiday pay for accrued but untaken holiday.
• Contractual bonus or commission that you have earned.
• Contractual payment in lieu of notice.
• Post-employment notice pay (see below).
• Benefits you keep after leaving, such as a car, depending on how they are provided.

Post-employment notice pay

Since 6 April 2018, if you do not work all or part of your notice period, the basic pay you would have received during that unworked notice is treated as earnings and taxed in full. This applies even if the agreement calls the payment compensation or ex gratia. HMRC calls this post-employment notice pay. Only the balance above it can benefit from the £30,000 exemption.

This is one of the most common reasons why the tax on a settlement payment is higher than an employee expected. A careful adviser checks the calculation.

Injury and disability payments

Payments made because of injury or disability can be exempt in full, but the rules are narrow. Since April 2018, payments for injury to feelings in discrimination cases generally do not qualify, unless the injury amounts to a psychiatric injury or other recognised medical condition. Get advice before relying on this.

Pension contributions

Some agreements allow part of the payment to be paid into a registered pension scheme instead of cash. Employer pension contributions are not usually taxed as income, but annual allowance limits apply. Consider it with your adviser, and a financial adviser if the sums are large.

Your legal fees

Your employer's contribution to your legal fees is not taxable if the payment is:

• for legal costs incurred only in connection with the termination of your employment;
• provided for in the settlement agreement; and
• paid directly to your lawyer.

That comes from section 413A of the Income Tax (Earnings and Pensions) Act 2003. See who pays for settlement agreement advice.

The tax indemnity

Most settlement agreements say that if HMRC later decides more tax is due on a payment, you will repay your employer. Your adviser should explain this clause and check that the tax treatment set out in the agreement looks right.

A simple example

An employee with five years' service, aged 35, earning £900 a week, is placed on garden leave and then leaves without working the final four weeks of notice. They are offered statutory redundancy pay plus an ex gratia payment.

• Statutory redundancy pay: 5 weeks × the capped weekly pay of £751 = £3,755.
• Four weeks' unworked notice: about £3,600 of post-employment notice pay, taxed as earnings.
• An ex gratia payment of £20,000, which together with the redundancy pay stays under £30,000 and is usually tax-free.

This is an illustration only. Your figures depend on your contract and the agreement.

Next step

I check the tax treatment as part of every settlement agreement review, and in most cases the fee is paid by your employer. See the settlement agreement service page, redundancy and settlement agreements, or send me your employer's name and your deadline through the enquiry form.