8 min Read
12 Apr 2013

Written by Darren

I’m an Independent Financial Adviser and I’ve been in the industry since the 90’s

I have always had a particular interest in Investment, including Pensions.

FPC qualified since 1999 I have now been qualified at the new Diploma level since July 2011.

I totally support the FSA initiative of raising standards in general and building a code of ethics for advisers.

My only regret is that the move to fee based advice in 2013 may put off those who don’t usually seek the services of advisers, and sometimes these are the people that need us most.

That’s why I’m happy to offer my services to Money To The Masses!

More about Darren

How to minimise the tax payable on a redundancy payment

Get an answer to your financial question online Reader Question:

Hi,

I am due to receive a redundancy payment of £116,000. How can I reduce the tax I will have to pay on this amount?

FREE guide on how to minimise your tax bill*

Darren's response:

Sorry to hear you've been made redundant, but at least you have a reasonable settlement to soften the blow. With regards to saving tax on the settlement it depends on what you actually mean, and what you intend to do now. Did you mean reducing the taxation of the actual settlement payment?

How your redundancy payment is taxed

  • The first £30,000 of a redundancy settlement is usually untaxed, although this figure can reduce in certain circumstances.
  • The rest of the money is deemed to be "wages" (holiday pay, Lieu of notice etc.) so is taxed.
  • The size of your settlement suggests that part, or all, of yours will be taxed at the higher rate of 40%, although ultimately which part depends on whether you take another job in the current tax year.
  • Any overpaid tax will be refunded when you complete your tax return

Using a pension to reduce your tax bill

The best way to reduce the taxation on the settlement is to use the funds to increase your pension benefits in retirement, by investing into a pension scheme. You will automatically gain back the income tax on the amount invested at the rate paid.

Let's assume that £30,000 is indeed non-taxable. That leaves £86,000.

I'll assume you have other employment that fully uses your tax allowances & 20% tax band, so the funds are taxed at 40%, leaving you with £51,600. You decide to invest the whole £86,000 into a personal pension, but you immediately gain tax relief at 20%. This means that you write a cheque for £68,800 but £80,000 goes into the pension

As a higher rate taxpayer you will complete a tax return and enter on this that you have made this contribution. The taxman will then refund a further 20% or £17,200 to you. Having written a cheque for £68,800, and then received £17,200 back, you have had a net outlay of £51,600. This is the net pay you received, but you have a full £86,000 in the pension. In simple terms that's it.

Carrying forward pension contributions

Unfortunately the maximum contribution in any tax year is restricted to either the amount you actually earn, or £50,000 whichever is the lower figure. The £86,000 is regarded as pensionable income for this purpose, but not the £30,000. As we have just started a new tax year, if we assume you take no other employment then you are capped at £50,000 for 2013/2014 tax year.

Fortunately that's not the end of the story, as we are allowed to backdate contributions to previous tax years going back 3 years. We do have to fully use the 2013/2014 allowance first, followed by unused allowances 3 years ago, and then 2 years ago, and finally last year

In your case you could potentially look back 3 years to the 2010/2011 tax year, taking into account your contributions in that period. If contributions in that year are under £14,000 then you could put the remaining £36,000 as being paid in 2010/2011. If however you had contributed £20,000 then you  can contribute only £30,000, and then you would have to see if you have £6,000 unused allowances in 2011/2012.

This carry forward process is a little complicated as a financial adviser needs to allow for what are referred to as input periods, and also calculations need to take account of actual earnings, and other pension contributions etc.

There is the additional difficulty in that at this point I'm assuming you don't know what income you will have from employment this year, and what pension contributions will be made. Obviously you may already have new employment arranged, and therefore will know these figures.

Immediate vesting

You haven't mentioned your age, and obviously this might make a difference to you as ideally a pension should be invested for the longer term. However, if you are over 55 you can take advantage of the "immediate vestment" option. I'll ignore any other pension that you may have (which can simply be added) and assume you invest the £86,000.

Assuming you are currently aged 55 you can "vest" (or cash in) the pension. taking 25% as a tax free sum, so you get back £21,500 immediately, untaxed. So at this point you are only £30,100 down on your original position of having £51,600 after tax.

If you wish you can then draw income of over £3,000 per year (this figure will increase dependant upon your actual age etc). The income is liable to taxation just like any other income.

You can choose not to draw this income until later years, which could increase the amount when you decide to begin drawing it, and perhaps allow it to be drawn at a lower tax rate.

Other options

If the above doesn't meet your needs then you'll just have to accept that your redundancy payment has has to be taxed, and then ensure that whatever investment you make going forward is as tax efficient as possible. This would include using your full ISA investment allowance for this year, and investing in a way that allows you to utilise your ISA account with each future tax year. You should also consider investments that utilise your Capital Gains Tax allowances.

I have tried to keep it as simple as possible, but the pension rules in particular are indeed quite complicated and you should seek independent financial advice before doing anything.

Best Wishes

Darren Amos

Financial Planning Designer

If you would like to contact Darren for help with your financial affairs you can do so via the 'contact the adviser' button below.

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Comments

  1. K Reed July 10, 2013 at 10:54 am

    Hi Darren – thanks for the advice on immediate vesting. I’ve left saving for a pension quite late, so this is something that I will definitely look into.

  2. HABIB HUSSAIN April 18, 2013 at 11:11 am

    I found your post very useful and current because I am going through exactly this kind of settlement agreement. What I did not understand is why the first £32k of income will not be taxed at 20%?

    1. Damien Fahy April 19, 2013 at 10:53 pm

      Hi, I’m not sure where you have got the £32k figure from. It is up to the first £30k of a redundancy payment which is not liable to income tax as per current tax legislation.

      Hope that helps

      Damien