Financial Planning With Redundancy Payments

Redundancies are an unfortunate consequence of current times. 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 is important that individuals facing redundancy understand what is included in their lump sum payments, how the payments are taxed and the impact the payments have on tax allowances and benefits. Here are some points to consider:

The termination ‘payment’

What you get paid when their employment terminates may 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.
• 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 have 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.
• Redundancy payments in respect of a ‘restrictive covenant’. This is where someone receives a payment for not doing something after leaving such as agreeing not to take clients or work for a competitor.

The employer should deal with the tax due on the termination payment through the PAYE system, but it is still important that an employee understands how they are 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 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, but employees pay no NI on this. However, since the start of this tax year, employers pay NI at 13.8% on this excess amount.
• Salary, holiday pay and PILON payments are generally fully taxable, and no part is tax free. They 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.

The wider impact of receiving a termination payment

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. This includes:

• Personal allowance – the personal allowance is reduced by £1 for every £2 of adjusted net income (ANI) over the income limit of £100,000. That means that, in the current tax year, personal allowance is completely lost when ANI exceeds £125,000.
• Child benefit – child benefit is reduced if adjusted net income exceeds £50,000 and is totally lost if it exceeds £60,000.
• Pension annual allowance – the standard annual allowance is £40,000 but can be tapered down to a minimum of £4,000 for high earners if income is in excess of £200,000.

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. However, 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.

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. It also reduces ANI, perhaps reinstating the personal allowance, which on its own is worth £5,000 to a higher rate taxpayer, or child benefit.

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 that employer pension contributions are not normally subject to NI and employers 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 could be sacrificed, there are no tax or NI advantages in doing so.

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 an annual allowance tax charge.

Pension funding by individual contribution

While employees 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 an employee’s annual allowance would otherwise be tapered.

There are several things to consider when making an individual payment into a pension.

• Relevant UK Earnings – individuals must have enough relevant UK earnings to get full tax relief on the contribution. Relevant UK earnings are broadly any pay taxable in the UK, including benefits in kind but not including the £30,000 tax-free part of the termination payment, dividends, rent or other savings income. If an employee doesn’t have sufficient relevant earnings (or annual allowance) they could think about making a contribution to their spouse/partner’s pension – provided they themselves have the scope to do so.
• Annual allowance – individuals must also have enough annual allowance available otherwise the tax relief given on any excess will be clawed back through self-assessment. But redundancy payments can result in the annual allowance being tapered.

Summary

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.