Retirement & Pensions

Tax planning with redundancy payments

By October 30, 2020 No Comments

As the effects of COVID-19 continue to be felt across the globe, here we continue to face the uncertainties relating to restrictions and measures and despite the government’s efforts to help protect people’s livelihoods, redundancies are a regrettable consequence of the pandemic.

For those facing redundancy, it is important to understand what is included in the redundancy payment, how it is taxed and the impact the payment could have on tax allowance and benefits.

Here split over three sections, we consider 10 key considerations we feel can help support those receiving redundancy payments, to help them plan for the future and consider how a pension contribution can have a positive effect on an individual’s overall wealth.

The payment itself

  1. What may be included in the ‘redundancy package’?

What somebody gets paid when their employment is terminated may comprise of several elements which may include:

  • Statutory or enhanced redundancy pay for loss of employment. This is what most people understand as redundancy pay. During the pandemic, the Government has confirmed that statutory redundancy should be based on the employees “normal wages” and not their furloughed pay.
  • Other pay received for duties and responsibilities performed before leaving, including salary, bonus, commission and holiday pay.
  • Payment in lieu of notice (PILON). This 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 work for a competitor. This would include ‘garden leave’ where an employee agrees not to work at all for the leave period.
  1. How is the payment taxed?

For those receiving a redundancy payment, their employer should deal with the tax due on their termination payment through the PAYE system. However, it is still important to understand how the payment is taxed and the wider impact this can have on tax related allowances and benefits.

The following is a general overview:

Statutory and enhanced redundancy payments are free of tax and National Insurance (NI) for the first £30,000 and has no effect on the tax rates paid on other income.

Any excess above £30,000 is however fully taxable, but the individual is not liable for any NI on this. However, since the start of this tax year, employer NI at 13.8% is payable on this excess amount, which in turn potentially increases the attractiveness of a pension sacrifice arrangement, as discussed in point 9 later in this article.

Redundancy payments are treated as received when the individual becomes entitled to the payment and it is therefore not possible to spread the payment over two or more tax years.

Salary, holiday pay and PILON payments within a redundancy payment are generally fully taxable, and no part of these payments are tax free, even if the full £30,000 tax free amount available to statutory and enhanced redundancy pay has not been fully used. These payments are also subject to employer and employee NI.

Employer pension contributions are not taxable in the hands of an employee, and they are not subject to employer or employee NI.

Restrictive covenants are normally taxed in the same way as pay, but professional advice should be sought in this area.

Considerations and impact of receiving a redundancy payment

Receiving a large lump sum in one tax year can have an impact in several ways. These can include moving an individual into a higher tax band, lose or reduction of allowances and benefits, all of which could increase the effective rate of tax for that year. Some of these areas include:

  1. Higher tax rates

As mentioned above, whilst the first £30,000 of the redundancy payment is tax free, the taxable elements could fall into  higher tax brackets e.g. moving from basic rate tax to higher rate tax, especially if redundancy occurs towards the end of the tax year when a large proportion of the annual salary has already been received. In addition, the order of taxation means that a redundancy payment can push savings income, dividends and capital gains into higher rates, because these all sit on top of earned income.

  1. Personal allowance

The personal allowance, £12,500 for the current tax year, could be reduced due to the redundancy payment. For every £2 of adjusted net income over the income limit of £100,000, £1 of personal allowance will be lost. This means that, in the current tax year, the personal allowance is wiped out when adjusted net income exceeds £125,000.

If this happens, the individual receiving the redundancy payment may have further tax to pay at the end of the year as the amount deducted via PAYE is unlikely to account for the loss of the personal allowance. This is likely to be picked up on when the individual completes their self-assessment or starts a new job.

A redundancy payment could also impact on the personal savings allowance, which might also be reduced from £1,000 to £500 or lost altogether if total income exceeds £150,000.

  1. Child benefit

For those currently receiving child benefit, the impact of a redundancy payment could mean this benefit is lost altogether. Child benefit is reduced where 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.

  1. Pension annual allowance

The standard annual allowance is £40,000 but this can be reduced to £4,000 depending on the level of income earned within the tax year. For this tax year, if an individual’s threshold income is more than £200,000 and their adjusted income is more than £240,000, their annual allowance will be reduced. The reduction is £1 for each £2 of adjusted income over £240,000. Those individuals previously unaffected could be caught depending on the size of their redundancy payment.

How paying into a pension can help

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

  1. Pension tax relief

The tax relief available 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. This might be even more if extra savings can be made where the personal allowance is restored (discussed in the following point), 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 payment.

  1. Reducing tax rates and reinstating allowances

Making a pension contribution, whether as a personal contribution or an employer contribution through salary sacrifice, could reduce tax rates paid on total income, perhaps from 45% to 40% or from 40% to 20%. A pension contribution would also reduce an individual’s adjusted net income, which may reinstate the personal allowance. This considered on its own would be save £5,000 in tax for a higher rate taxpayer.

The same is true for child benefit. If adjusted net income can be reduced to £50,000, this could reinstate the child benefit, which could be worth an extra £2,500 for a family with three children.

  1. Pension funding by salary sacrifice

Some employers may offer or agree to sacrifice some or all of the redundancy payment for a pension contribution. The advantage to the employer is 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. If this is possible, it makes sense to make this 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).

Whilst the £30,000 tax free element could be sacrificed, there are no tax or NI advantages in doing so. And as discussed in the following point 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 the individual’s threshold income. This contrasts with an individual contribution, as we shall see below.

  1. Pension funding by individual contribution

Whilst individuals may benefit from NI savings made under a sacrifice arrangement, not all employers may be willing to offer this option. Therefore, a personal contribution still makes sense, and may even be preferable if the annual allowance of the individual 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 – individuals must have sufficient relevant UK earnings to get full tax relief on the contribution. Relevant UK earnings are broadly any type of income which are taxable in the UK, including benefits in kind. Only the redundancy payment over the tax-exempt threshold of £30,000 will be classed as employment income and therefore count as relevant UK earnings e.g. a £40,000 redundancy payment would have £10,000 counted as relevant UK earnings. The £30,000 tax free part of the termination payment, plus dividends, rent and other savings income are the main items excluded from relevant UK earnings. And if an individual does not have sufficient relevant earnings (or annual allowance) they could think about contributing to their 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 – individuals must have sufficient 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 tax year. As discussed earlier, 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.

Summary

The prospect of redundancy can be a difficult and worrying time for many people. However, for some it can provide a welcome cash injection that could mean retirement plans can be brought forward or savings boosted if they can quickly find suitable new employment. The above highlights some of the various considerations and impact of a redundancy payment can have, and the complexities associated with how best to handle and manage the payments. However, the right financial and tax planning, those retirement and savings ambitions could be further enhanced.