Tax planning with redundancy payments
Redundancies are an unfortunate consequence of current times. And with the Government’s furlough scheme coming to an end, there may be more employers who will need to make cuts to their workforce.
It’s important that those facing redundancy understand what is included in their lump sum payment, how it’s taxed and the impact the lump sum has on their tax allowances and benefits.
In this insight we look at 10 key facts you should know in relation to redundancy payments to help plan for the future, including how a pension contribution can have a positive effect on your overall wealth.
The termination ‘payment’
- What may be included in the ‘redundancy package’?
What you get paid when your employment terminates may comprise several elements. The payment may include:
- Statutory or enhanced redundancy payfor loss of office. This is what most people understand as redundancy pay – the bit where the first £30,000 is received tax free. It’s interesting to note here that the Government has confirmed that statutory redundancy should be based on an employee’s normal wages and not their furloughed pay.
- Other payreceived 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 notdoing 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.
- How is it taxed?
Your employer should deal with the tax due on their termination payment through the PAYE system, but it’s still important that you understand how you’re taxed and the wider impact this has on your tax related allowances and benefits. The following is a general overview:
- Statutory and enhanced redundancy paymentsare free of tax and 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, but employees pay no NI on this. However, since the start of this tax year, employer NI at 13.8% is payable on this excess 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 contributionsare not taxable in the hands of an employee, and they’re not subject to employer or employee NI.
- Restrictive covenantsare normally taxed in the same way as pay, but professional advice should be sought.
The wider ’ impact’ of receiving a termination payment
Receiving a large lump sum in one tax year can push you into higher tax bands, and result in lost allowances and benefits, increasing the effective rate of tax for that year. This includes:
- 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. In addition, the order of taxation means that the redundancy package can push savings income, dividends and capital gains into higher rates, because these all sit on top of earned income. The personal savings allowance might also be reduced from £1,000 to £500, or lost altogether if total income exceeds £150,000.
- 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. That means that, in the current tax year, personal allowance is wiped out when adjusted net income exceeds £125,000.
If this happens, you may have further tax to pay at the end of the year as the amount deducted via PAYE is unlikely to account for the lost personal allowance. This generally gets picked up when you complete your self-assessment or start a new job.
- Child benefit
For those currently receiving child benefit, the impact of the payment could mean it’s lost altogether. Child benefit is reduced if adjusted net income exceeds £50,000 and is totally lost if it exceeds £60,000. The amount of child benefit is dependent on the size of the family – for example, a family of 3 children could lose around £2,500 a year.
- Pension annual allowance
The standard annual allowance is £40,000 but can be tapered down to a minimum of £4,000 if you are a high earner. Those previously unaffected could be caught due to the size of your redundancy package. For this tax year, if your threshold income is more than £200,000 and your adjusted income is more than £240,000, your annual allowance will be reduced. The reduction is £1 for each £2 of adjusted income over £240,000.
How paying into a pension can help
It might seem counter intuitive to you 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 could 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 addition to pension savings comes at a net cost of £12,000 for a higher rate taxpayer. This might be even more if extra savings can be made where the personal allowance is restored or child benefit can continue from making a pension contribution. And potentially much more can be paid into a pension in a single tax year than the next best home, an ISA, particularly in the year of receipt of a redundancy package.
- Reducing tax rates and reinstating allowances
Making a pension contribution, whether as a personal contribution or an employer contribution through salary sacrifice, will reduce tax rates paid on total income, perhaps from 45% to 40% or from 40% to 20%. It also reduces your ‘adjusted net income’ (ANI), perhaps reinstating the personal allowance which on its own is worth £5,000 to a higher rate taxpayer.
The same is true for child benefit. If ANI can be reduced to £50,000, this could wipe out the child benefit tax charge, which could be worth an extra £2,500 for a family with three children.
- Pension funding by salary 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 13.8% 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. For example, the optimum order may be PILON payments, (because these are subject to both employer and employee NI), then the taxable part of the redundancy payment for loss of office (because employer NI is due on these).
While the £30,000 tax free element could be sacrificed, there are no tax or NI advantages in doing so. And as discussed below, it may be better to pay it as a personal contribution.
In particular, 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 is in contrast to an individual contribution, as we shall see below.
- Pension funding by individual contribution
While you may benefit from NI savings made under a sacrifice arrangement, not all employers may be willing to offer this option. A personal contribution still makes sense, and may even be preferable if your annual allowance would otherwise be tapered.
There are several things to consider when making an individual payment into a pension.
- National Insurance – there are no NI savings to be made, unlike a sacrifice.
- Relevant UK Earnings – clients must have enough relevant UK earnings to get full tax relief on the contribution. In fact, most providers will not accept contributions in excess of earnings. Relevant UK earnings are broadly any pay taxable in the UK, including benefits in kind. The taxable part of the redundancy package will obviously boost earnings and the potential for a large pension contribution. The £30,000 tax free part of the termination payment, plus dividends, rent and other savings income are the main items excludedfrom relevant UK earnings. And if you don’t have sufficient relevant earnings (or annual allowance) you could think about making a contribution to your spouse/partner’s pension – provided they themselves have the scope to do so.
- Earnings from abroad– earnings not taxable in the UK due to a double taxation agreement will not be included in relevant UK earnings
- Annual allowance – you must also have enough annual allowance available otherwise the tax relief given on any excess will be clawed back through self-assessment. Unused allowances from the last three tax years can be added to the annual allowance for the current year. But obviously receiving a taxable lump sum on redundancy can mean that the adjusted income limit of £240,000 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 £40,000 annual allowance. As mentioned above, this is not possible if the pension contribution is made by sacrifice.
The prospect of redundancy can be a difficult time for many people. But, equally, 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.