Redundancy payments and tax: How to reduce tax on your redundancy payment

 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?

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Our 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.

We've assumed you have other employment that fully uses your tax allowances and 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 £86,000 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% of £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 £40,000 for the 2022/23 tax year (this is increasing to £60,000 from 2023/24 onwards) whichever is the lower figure. The £86,000 is regarded as pensionable income for this purpose, but not the £30,000. As we are into a new tax year, if we assume you take no other employment then you are capped at £40,000 for 2022/2023 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 2022/2023 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 2019/2020 tax year, taking into account your contributions in that period. If contributions in that year are under £4,000 then you could put the remaining £36,000 as being paid in 2019/2020. If however, you had contributed £20,000 then you can contribute only £20,000, and then you would have to see if you have £16,000 unused allowances in 2020/2021.

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 an income via an annuity of around £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 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.

We 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.

 

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