Techzone

Overview

The prospect of redundancy can be a difficult time for many people. But, for some, it can be a welcome cash injection that could mean retirement plans can be brought forward or savings boosted if they can quickly find suitable new employment. With the right tax planning, those retirement and savings ambitions could be further enhanced.

It’s important that those facing redundancy understand what is included in their proposed redundancy package, how it will be taxed and the impact it could have on their tax allowances and benefits.

The redundancy package

When an individual’s employment is terminated, their ‘redundancy package' could comprise several elements. The payment may include:

• Statutory or enhanced redundancy pay for loss of office. This is what most people understand as redundancy pay – where the first £30,000 is received tax-free.
• Other pay received for duties performed before leaving, including salary, bonus, commission and holiday pay.
• Payment in lieu of notice (PILON) is paid where the employee leaves before they've worked their full notice period under their contract of employment and are entitled to be paid for the period between leaving and the end of the notice period.
• An employer pension contribution. This may include contractual pension contributions which the employer is obliged to make for the balance of any notice period.
• Payments in respect of a ‘restrictive covenant’. This is where someone receives a payment for not doing something after leaving. For example, an employee agrees not to take clients from their ex-employer, or work for a competitor. This includes ‘garden leave’ where an employee agrees not to work at all for the leave period. These will be less common.

Taxation of the redundancy package

The employer should deal with the tax due on their termination payment through the PAYE system, but it’s still important to understand how the employee is taxed and the wider impact this has on their tax related allowances and benefits. The following is a general overview:

• Statutory and enhanced redundancy payments are free of income tax and National Insurance (NI) for the first £30,000 and has no effect on the tax rates paid on other income. The excess above £30,000 is fully taxable and sits above dividend income, but before investment bond gains in the order of taxation.
  
  Employees pay no NI on the termination payment, but employer NI at 15% is payable on the excess over the tax-free amount, potentially increasing the attractiveness of a sacrifice arrangement to pension, as we'll see later.
• Redundancy payments are treated as received when the employee becomes entitled to the payment and it's not therefore possible to spread the payment over two or more tax years.
• Salary, holiday pay and PILON payments are generally fully taxable, and no part is tax-free, even if the full £30,000 tax-free amount available to statutory and enhanced redundancy pay has not been fully used. They're also subject to employer and employee NI.
• Employer pension contributions are not taxable in the hands of an employee, and they're not subject to employer or employee NI.
• Restrictive covenants are normally taxed in the same way as pay, but professional advice should be sought.

The wider financial impact of redundancy

Aside from those individuals who jump straight into another job, redundancy will of course result in a loss of earnings. The lump sum received on redundancy does help buy some time for those who need to find employment again, but it can also create some issues.

Receiving a large lump sum in one tax year can push an individual into higher tax bands, and result in lost allowances and benefits, increasing the effective rate of tax for that year. The implications of the payment include:

• Higher tax rates
  
  Whilst the first £30,000 of the redundancy payment is tax-free, the taxable elements can frequency fall into higher tax brackets, especially if redundancy occurs late in the tax year when a large proportion of the annual salary has already been received.
  
  The personal savings allowance might also be reduced from £1,000 to £500, or lost altogether if total income exceeds £125,140.
• Personal allowance
  
  The personal allowance can also be reduced when someone receives a redundancy package. For every £2 of adjusted net income (ANI)* over the income limit of £100,000, £1 of personal allowance will be lost. This means that, in the 2025/26 tax year, the personal allowance is completely lost when adjusted net income reaches £125,140.
  
  If this happens, the individual may have further tax to pay at the end of the tax year as the amount deducted via PAYE is unlikely to account for the lost personal allowance. This generally gets picked up when the client completes their self-assessment or starts a new job.
  
  * Note that the £30,000 tax-free element of redundancy payments doesn’t count towards ANI.
• Child Benefit
  
  For those currently receiving Child Benefit, the impact of the payment could mean it's lost altogether. Where someone in the household has ANI of more than £60,000, the benefit begins to be withdrawn by way of a tax charge - the High Income Child Benefit Charge - at the rate of 1% of the benefit for every £200 over this threshold. Child Benefit will be cancelled out completely for those on £80,000 or more.
  
  For example, in the 2025/26 tax year this could mean losing out on:
  
  
  • £1,354.60 for a family with one child
  • £2,251.60 for a family with two children
  • £3,148.60 for a family with three children
• Pension annual allowance
  
  The standard annual allowance is £60,000 but it can be tapered down for high earners – potentially to as low as £10,000.
  
  Individuals previously unaffected could be caught due to the size of their redundancy package. For the 2025/26 tax year, if an individual's threshold income is more than £200,000 and their adjusted income is more than £260,000, their annual allowance will be reduced at a rate of £1 for every £2 of adjusted income over £260,000.
  
  For more detail on tapering, see our ‘Annual allowance’ guide.

How paying into a pension can help

It might seem counter intuitive to make a pension contribution at a time when easy access to cash is a priority. But this could deliver better financial outcomes if there are other assets that can be used to cover current income needs.

Pension tax relief

The tax relief on pension contributions make them the most tax effective way of saving for retirement. A £20,000 pension contribution comes at a net cost of £12,000 for a higher rate taxpayer.

To consider the effectiveness of pension saving, let’s compare it to its nearest tax privileged rival – the ISA. Both pensions and ISAs protect savings from income tax and capital gains tax. But it’s the tax relief on contributions and tax-free cash available on withdrawals that set them apart.

This presents a strong argument in favour of funding pensions before ISAs where the goal is retirement income. Only individuals taking withdrawals containing no tax-free cash and paying tax at a higher rate on withdrawals than tax relief received on contributions will be potentially worse off.

And potentially much more can be paid into a pension in a single tax year than an ISA, particularly in the year of receipt of a redundancy package where this boosts the individual’s relevant UK earnings.

Reducing tax rates and reinstating allowances

Making a pension contribution, whether as a personal contribution or an employer contribution through salary sacrifice, can reduce tax rates paid on total income, perhaps from 45% to 40%* or from 40% to 20%*.

It also reduces the individual’s ‘adjusted net income’ (ANI), perhaps reinstating the personal allowance, which on its own is worth £5,028 to a higher rate taxpayer.

The same is true for Child Benefit. If ANI can be reduced to £60,000, this could wipe out the High Income Child Benefit Charge.

* Different rates apply in Scotland.

Pension funding by redundancy sacrifice

Some employers may offer or agree to a sacrifice on some or all of the redundancy payment. The advantage is of course that employer pension contributions are not normally subject to NI at 15% and they may be willing to pass this saving on to the employee. Therefore it makes sense to make the sacrifice from those parts of the redundancy payment that are subject to NI in the first instance.

While the £30,000 tax-free element can be sacrificed, there are no tax or NI advantages in doing so. And as covered below, it may be better to pay it as a personal contribution.

Higher earners choosing the redundancy sacrifice option can sometimes cause the annual allowance to be tapered, restricting the amount that can be paid into pension without incurring a pensions annual allowance tax charge. This is because any new sacrifice arrangement is included in a client's threshold income. This contrasts with an individual’s personal contribution, as we’ll see below.

Pension funding by an individual’s contribution

While an individual could benefit from NI savings under a sacrifice arrangement if part of their package was subject to NI, not all employers may be willing to offer this option.

A personal contribution can still make sense and could even be preferable if the individual’s annual allowance would otherwise be tapered.

There are several things to consider when an individual makes a personal contribution into a pension.

• National Insurance - there are no NI savings to be made, unlike a sacrifice.
  
  
• Relevant UK earnings - individuals must have enough relevant UK earnings to get full tax relief on the contribution. In fact, most providers will not accept personal contributions in excess of their earnings. Relevant UK earnings are broadly any pay taxable in the UK, including benefits-in-kind.
  
  The taxable part of a redundancy package will obviously boost earnings and the potential for a large pension contribution. However, the £30,000 tax-free element is excluded from relevant UK earnings.
  
  If the individual doesn't have sufficient relevant UK earnings (or annual allowance) to make the size of contribution they’d like to, they could consider contributing to their spouse/partner’s pension – provided they themselves have relevant UK earnings to justify the tax relief.
  
  
• Annual allowance - individuals must also have enough annual allowance available, otherwise the tax relief given on any excess will be clawed back via the annual allowance tax charge. Unused annual allowance from the last three tax years can normally be carried forward to boost the amount that can be paid in the current year.
  
  Receiving a taxable lump sum on redundancy could mean that the adjusted income limit of £260,000 is breached, resulting in a reduced annual allowance for the current year. To remedy this, an individual contribution may be enough to reduce threshold income to below £200,000, restoring the full £60,000 annual allowance. As mentioned above, this is not possible if the pension contribution is made by sacrifice.