Reader’s Question – How can I avoid paying tax on my redundancy payment?

Reader’s Question – How to pay less income tax on a redundancy payment

I'm shortly to be made redundant. I understand that any monies due to me over £30,000 (not including Lieu of notice which tax and NI will be taken off at source) I will be liable to pay tax on and this may push some of my redundancy into the 40p tax bracket. Apart from putting it into a pension, is there anyway I can avoid paying this tax, such as spending on home improvements?

My response:

That’s a good question.

For clarity let me briefly explain the £30,000 limit for other readers. Generally speaking the first £30,000 of redundancy pay is not taxable providing certain criteria laid down by the taxman are met (i.e. that it is not part of a retirement package).

After that anything in excess of this limit is taxed at your marginal income tax rate. So if you pay 40% tax then unfortunately your lump sum amount over £30,000 will get hammered by the tax man (he’ll tax 40% of it). For the record you won’t pay National Insurance on any part of your redundancy payment.

So what can you do to avoid tax on your redundancy payment?

First things first:

Read HMRC’s redundancy factsheet.
Next speak to your employer and check that they have ensured that your redundancy fits the tax man’s criteria to ensure that you don’t pay tax on the first £30,000.
Usually as part of any redundancy procedure an employer will offer some HR services such as a careers adviser etc. Ask to speak to the company’s tax accountant as they should be able to help you with any tax queries.

But in the meantime I’ve set out a few pointers that may help:

Pensions

As you state in your question, the number one way to avoid tax on a redundancy payment is to have some of it paid into a pension. That way you could reclaim the income tax and the gross amount could be used to fund your retirement. But the major downside of this is that your money is locked up in a pension until you are age 55.

Under current rules you could then only take 25% of the pension fund as a tax free lump sum while the rest would have to provide you with a retirement income. There are odd exceptions to this rule such as the ‘pension triviality’ scenario. However, pension rules are changing which will give people greater access to their pension fund. If you want to explore the pension route further then take financial advice as the legislation/proposals are a bit of a minefield.

Obviously there are limits to how much you can pay into a pension in any event, although you could technically pay into one on behalf of a spouse or child and claim a limited amount of tax relief.

Tax incentivised investments

There are tax incentivised investments such as VCTs which give you income tax relief at outset. But I would strongly suggest that these would not be appropriate for a redundancy payment you need to live on. They tend to be very high risk and you are in danger of losing the initial capital invested. You should never enter an investment just to save tax. I only mention tax incentivised investments for completeness of my answer. Always seek financial advice before doing anything.

Income tax mitigation

Another way to look at the problem is to not concentrate on the redundancy payment itself but look at reducing your income tax bill elsewhere. That way less of your redundancy payment will fall into the 40% tax bracket. You could do this by deferring any unneeded income until the next tax year or by moving any income producing assets such as savings into a spouse’s name. Read my post Money tip #81 – Utilise your family’s annual tax allowances and slash your tax bill for more information. Unfortunately, we are at the end of the tax year and as an employee paid under PAYE your options for reducing your income tax bill may be limited unless you…..

Delay your redundancy

Is there anyway you can delay the termination date of your employment until after 6^th April 2011? If you were able to then you will not be a 40% income tax payer as you won’t have had any earnings. You would then have time (namely the rest of the tax year) to manage your future income in order to pay as little tax on your redundancy payment as possible.

Get your redundancy after you leave

If you are paid your redundancy after you have left employment then legally your employer can only deduct 20% tax from the taxable part of your redundancy lump sum. The balance of any tax due on this part (a further 20% in your case) will be payable on 31^st January 2012 if you are made redundant in this tax year. You will have to pay this via self assessment. Obviously if you were made redundant after April 2011 then the balance of any tax you owe will not be payable until 31^stJanuary 2013. But whatever happens the tax man will want his money so make sure you have a means of paying him. But ultimately this delayed payment route doesn’t save you tax it just spreads out the payment of it.

UPDATE: 19th April 2011. The statement above used to be true but a change in the rules in recent weeks now means that redundancy payments paid after you leave will be taxed as if they are earnings accrued in one month. The tax man will assume this situation will continue so will artificially inflate your projected earnings for the year. So in theory it will only take a total redundancy payment of over £42,500 to mean that the taxable part of your redundancy will start to be taxed at 50%. Annoyingly you will then need to go about claiming this overpayment of tax back from the tax man which is another headache you probably could do without.

Hope that gives you some food for thought. But as I mentioned earlier, discuss your redundancy with your employer and their accountant and ensure that it is done is as tax efficiently was as possible for you. Not only is it the least they can do, but it is in their interest as it will save them tax as well.

Good Luck