Is a Settlement Agreement Taxable? A Simple Guide for Employees

Understanding the tax implications of a settlement agreement is crucial if you need to know how much you’ll receive. Without clarity on the tax aspect of what you’re being offered, you might find yourself with less than expected.

Your employer may offer a specific settlement amount, but calculating what you actually receive after deductions for income tax and National Insurance is another matter entirely. The last thing you want is a nasty surprise when your payout is smaller than expected due to deductions.

In this guide, you’ll learn all you need to know about the tax implications of a settlement agreement and how to ensure you don’t pay more tax than you need to.

What is a settlement agreement?

A settlement agreement is a legally binding contract between you and your employer. In exchange for a sum of money, you waive your rights to bring legal claims against your employer, often in situations like redundancy, unfair dismissal, or workplace disputes.

To learn more, read our free guide: What is a Settlement Agreement? Advice for Employees

How much tax will you pay on your termination payments?

Usually (but not always), an employer offers a settlement agreement because your employment is ending.

When you leave a job, whatever payments the company makes to you are called “Termination Payments” by HMRC. These include

• redundancy payments
• compensation for loss of employment, often referred to as an ex-gratia payment
• pay in lieu of notice (commonly abbreviated to PILON)
• holiday pay
• unpaid wages

As long as the settlement agreement payment is made because your employment is being terminated for whatever reason, then the tax laws covering Termination Payments will apply.

Let’s look at how the different types of payment are taxed.

Is an ex-gratia payment taxable?

Under UK tax law, the first £30,000 of your settlement payment is free from income tax and National Insurance. This part of the payment is often referred to as a ‘compensation’ or ‘ex-gratia’ payment, meaning it’s a goodwill payment not required by your employment contract.

The balance over £30,000 is subject to tax at the employee’s marginal rate. However, you won’t have to pay employee national insurance.

Is a redundancy payment taxable?

You may have been offered a settlement agreement as an alternative to redundancy. This usually means your employer will consider your statutory redundancy payment entitlement.

A statutory redundancy payment is a payment you are legally entitled to when your employment ends because of redundancy. It’s calculated according to your length of service, weekly pay and age. It is also subject to a cap, which changes each year. You can calculate your current entitlement on this government website. If you’re not sure how much your entitlement is, you may find it helpful to speak to a solicitor who specialises in settlement agreement advice.

Any statutory redundancy payment you receive can be paid tax-free in full.

Your employment contract may entitle you to receive more than the statutory minimum if you’re made redundant. This is known as a contractual redundancy payment.

If you’re receiving a contractual redundancy payment, the first £30,000 (including any statutory redundancy payment) is tax-free. The balance over £30,000 is subject to tax and employer National Insurance contributions (but not subject to employee National Insurance contributions).

For the avoidance of doubt, the £30,000 threshold applies to the total of your tax-free payments, including any redundancy or ex-gratia payment. You don’t get a separate £30,000 threshold for each sum you receive.

Is a Payment in Lieu of Notice (PILON) taxable?

Any payment in lieu of notice (PILON) in your settlement agreement is taxed like regular earnings. If you don’t serve your whole notice period and you also don’t receive a PILON, then a percentage of your settlement payment will be treated as post employment notice pay (PENP). This is also treated as salary and taxed. There is no way to avoid paying tax on notice pay. It’s not possible to avoid tax by paying post employment notice pay as part of the compensation payment.

Is holiday pay taxable?

When your employment ends, you can be paid for any holiday you haven’t taken. This also forms part of your taxable income, even if paid under a settlement agreement.

What about payments for restrictive covenants?

Restrictive covenants are agreements that limit your actions after leaving your job, like preventing you from working with competitors. Any payment you receive for agreeing to a restrictive covenant is taxable.

Your settlement agreement may include a nominal taxable payment, such as £250, for agreeing to restrictive covenants. That minimises the risk that HMRC will say that the compensation payment is actually a payment for entering into restrictions, which would lead to the whole payment becoming taxable.

Is compensation for discrimination subject to tax?

If you have been treated less favourably because of a protected characteristic, such as race, gender, disability, etc., you’re entitled to compensation. For a full list of protected characteristics, click here.

The compensation usually includes an element for injury to feelings, although it may include other factors, such as loss of earnings.

The tax status of a payment for discrimination depends on several factors.

• If the payment is compensation for injury to feelings arising from discrimination and the discrimination is not related to the termination of employment, it can be paid tax free.
• If the payment compensates for loss of earnings and the discrimination is not related to the termination of employment, the payment should be taxed
• If the payment compensates for injury to feelings and/or loss of earnings and the discrimination relates to the termination of employment, the payment can be paid tax free, subject to the maximum of £30,000

Settlement agreements are usually used when employment is ending, so the basic rule that the first £30,000 can be paid tax-free will apply.

How to minimise tax in a settlement agreement

In some circumstances, there may be ways you can reduce your tax liability when negotiating a settlement agreement. Every situation is different so you should make sure you get independent legal advice before deciding what to do.

Paying part of the taxable amount into your pension fund

You may be able to reduce your tax liability by asking your employer to pay some of the taxable amount into your pension. A registered pension scheme payment is usually tax-free, subject to pension contribution limits, but you won’t have immediate access to it.

If you’d like to consider this option, we recommend you speak to your pension fund administrators first. You may also want to seek independent financial advice on whether it’s the best option for you. Most solicitors are not authorised to give specific financial advice.

Deferring payment until the next financial year

As a general rule, you’re taxed on income when you become entitled to it.

Most employees want their termination payments as soon as possible. However, there may be some advantages to deferring payments. You could agree with your employer to defer payments until the next financial year to reduce tax liability if you pay tax at a lower rate in that year. 

This approach may be more attractive if you’re close to the end of the current financial year.

What happens if you don’t pay the right amount of tax?

Your employer should understand how different types of payments are taxed. But that’s not a guarantee that they’ll get it right.

Whether or not various payments are taxable is a matter of fact rather than choice. This means that even if your settlement agreement states a payment is tax-free, HMRC may take a different view.

If your employer gets the tax calculations wrong, HMRC may pursue them for unpaid tax. If they reclaim tax from your employer, a tax indemnity clause could mean your employer can claim it back from you. Tax indemnity clauses in agreements state that if HMRC later decides more tax should have been paid, the employee is responsible for paying that extra tax back to the employer. That’s why it’s essential to ensure the tax treatment is accurate. 

An employment solicitor can advise on whether the tax treatment of the payments is correct. You may need to obtain specialist tax advice if your settlement agreement is unusually complex.