Is a Settlement Agreement Taxable? Free Guide for Employees

How Much Tax Will You Pay on Your Settlement Agreement

If you want to know how much you’ll receive in a settlement agreement, you need to know a bit about tax.

It’s one thing to be told how much your employer is offering to pay you – it’s another thing to work out how much you will get after tax has been deducted.

The last thing you want after agreeing a settlement is to find out later you’re not going to get what you thought.

How much tax will you pay on your settlement agreement?

Usually (but not always) an employer offers a settlement agreement because your employment is coming to an end.

When you’re leaving a job, whatever payments the company makes to you are called “Termination Payments” by HMRC, regardless of whether they are redundancy payments, compensation for unfair dismissal, pay in lieu of notice (commonly abbreviated to PILON), holiday pay, or simply any wages owed.

As long as the 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 a settlement payment taxable?

The first £30,000 of a settlement payment is tax-free. Sometimes this is called a compensation payment or an ex-gratia payment.

Ex gratia just means, “as a gift”. In the case of tax law and employment, it means your employer was not obliged to pay it under the terms of your contract of employment.

Is a redundancy payment taxable?

Settlement agreements are often used in the context of a redundancy situation, sometimes as a way for your employer to avoid a redundancy procedure. This usually means your employer will consider your statutory redundancy payment entitlement.

A statutory redundancy payment is a payment that you are legally entitled to when your employment ends by reason of redundancy. It is calculated by reference 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.

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 is tax free. The balance over £30,000 is taxable.

For the avoidance of doubt, the £30,000 threshold applies to the total of your tax free payments. You don’t get a separate £30,000 threshold for each sum you receive.

Is a Payment in Lieu of Notice taxable?

If you’re receiving a payment in lieu of notice (“PILON”), that payment must be taxed as though you had worked your notice.

If you don’t serve your whole notice period and you don’t receive a PILON either, then some of your settlement payment will be treated as Post Employment Notice Pay (“PENP”). The rules are quite complicated but you should expect to be taxed on any amount of PENP.

This means there’s no way to avoid paying tax on notice pay.

Are wages taxed if paid as part of a settlement agreement?

Usually a settlement agreement will say that you will be paid as normal up to the termination date. These wages are due to you as part of your earnings and so they will be taxed in the normal way.

Is holiday pay taxable?

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

What about payments for restrictive covenants?

A restrictive covenant is an agreement that you will not do certain things within a certain period after leaving.

The purpose is to protect your former employer from losing business. For example, if you leave a hairdresser’s salon, you might agree not to open your own salon within a mile of your employer’s salon for a year after leaving.

Payments for agreeing restrictive covenants are considered to be earnings and are taxable. Usually, an employer will pay a nominal amount for you to agree restrictive covenants.

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 be paid compensation. For a full list of protected characteristics, click here.

The compensation will usually include 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 a number of factors.

  1. 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.
  2. If the payment compensates for loss of earnings and the discrimination is not related to the termination of employment, the payment should be taxed
  3. 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

Usually settlement agreements are used when the employment is coming to an end and 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 in a settlement agreement.

Paying part of the taxable amount into your pension fund

You could ask your employer to pay some of the taxable element into your pension fund. This usually means it can be paid tax free (subject to annual and lifetime contribution limits). However, it also means you don’t have immediate access to it.

If you’d like to consider this option, speak to your pension fund administrators first. You may also want to seek independent 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 advantage in deferring the payments. You could agree with your employer that they will pay you some of the taxable element in the next financial year. If you pay tax at a lower rate in that financial year, it will mean you pay less tax.

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 payments are treated for tax. 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 that a payment is tax free, HMRC may take a different view.

If that happens, HMRC is likely to claim any unpaid tax from your employer. Your settlement agreement probably includes a tax indemnity clause, which means that if your employer has to pay additional tax, they can claim it back from you. That’s why it’s important that the tax position is clear when you sign the settlement agreement.

Your solicitor will advise on whether the tax treatment of the payments is correct and whether there’s any way to save tax.

Contact Us For Advice on Your Settlement Agreement

If you have received a settlement agreement, you will need to make sure you receive legal advice on it.

We advise clients throughout the UK. Call us now for a free consultation. We provide clear and prompt advice on all aspects of your settlement agreement.

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