Understanding the tax implications of a settlement agreement is crucial if you need to know how much you’ll receive. Without clarity on settlement agreement tax, you might find yourself with less than expected.
Your employer may offer a specific settlement amount, but calculating what you actually receive after tax deductions is another matter entirely. The last thing you want is a nasty surprise when your payout is smaller than expected due to taxes.
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.
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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 settlement agreement?
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 unfair dismissal
- pay in lieu of notice (commonly abbreviated to PILON)
- holiday pay
- unpaid wages
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?
Under UK tax law, the first £30,000 of your settlement payment is tax-free. 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.
Is a redundancy payment taxable?
Settlement agreements are often used in 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 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.
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 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 (PILON) taxable?
Any payment in lieu of notice (PILON) is taxed like regular earnings. If you don’t receive PILON but leave early, part of your settlement may be classed as Post Employment Notice Pay (PENP), which is also taxable. Unfortunately, there’s no way to avoid 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 usual up to the termination date. These wages are due to you as part of your earnings, so they will be taxed normally.
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.
Often, a settlement agreement includes 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 in a settlement agreement.
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. This amount 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 that they will pay you some of the taxable elements in the next financial year. If you pay tax at a lower rate in that financial year, you will 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 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 in your settlement agreement could mean your employer can claim it back from you. That’s why it’s essential to ensure the tax treatment is accurate.
Your solicitor will advise on whether the tax treatment of the payments is correct and whether there’s any way to save tax.
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Andrew Crisp is the Principal Solicitor at Mason Bullock Solicitors, where he specialises in employment law and dispute resolution. With over two decades of legal experience, Andrew has built a reputation for his expertise in advising employees on settlement agreements and helping clients navigate complex litigation processes, including the removal of County Court Judgments (CCJs).