Unfortunately, the Covid-19 pandemic has already and will further see redundancies becoming more common place as businesses look to streamline costs. It is important for those in such circumstances to understand how a lump sum redundancy payment could impact their wider financial position.
The tax due on a termination payment is usually accounted for through the PAYE system, but it’s still important to understand how that payment is taxed and the impact on tax related allowances and benefits.
Statutory and enhanced redundancy payments for loss of office are received free of tax and National Insurance (NI) up to a limit of £30,000. The excess amount is subject to income tax. Employees do not pay national insurance on the excess amount but employers pay NI at 13.8%.
Redundancy packages also commonly account for salary, holiday pay, payment in lieu of notice and payment for periods of restriction, all of which are generally fully taxable and no part is tax free even if the full £30,000 tax amount available to statuary redundancy pay has not been used.
Statutory redundancy payments are treated as received when the employee becomes entitled to the payment, meaning it is not possible to spread the payment over two or more tax years.
Receiving a large lump sum redundancy payment in one tax year can push individuals into higher tax bands, and result in lost allowances and benefits, increasing the effective rate of tax for that year. Taxation consequences include:
- Higher tax rates
Whilst the first £30,000 of the redundancy payment is tax free, the taxable elements often fall into higher or additional tax brackets, especially if redundancy occurs late in the tax year when a large proportion of the annual salary has already been received.
This can have a knock on effect by pushing savings income, dividends and Capital Gains into higher rates of tax.
- Loss of personal savings allowance
The personal savings allowance might also be reduced from £1,000 to £500, or lost altogether if total income exceeds £150,000.
- Loss of personal allowance
Redundancy can often result in the loss of personal allowance. The personal allowance allows individuals to receive up to £12,500 per annum without any liability to income tax. However, for every £2 of adjusted net income over the income limit of £100,000, £1 of personal allowance will be lost. In the tax year 2020/21, the personal allowance is wiped out when adjusted net income exceeds £125,000.
If this happens, an individual may have further tax to pay at the end of the year as the amount deducted via PAYE is unlikely to account for the lost personal allowance.
- Loss of child benefit
Child benefit is reduced if 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.
- Reduced pension annual allowance
The standard annual allowance for pension contributions is £40,000 but can be tapered down to a minimum of £4,000 for high earners. Individuals previously unaffected could be caught due to the size of their redundancy package. 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.
What options are available to mitigate these costs?
It might seem illogical to make a pension contribution at a time when cash flow is a priority, however pension contributions may help better an individual’s financial position. The following points provide details of how pension contributions can help.
- Pension tax relief
A higher rate tax payer currently benefits from income tax relief of 40%. This means that a £10,000 addition to pension savings comes at a net cost of £6,000 for a higher rate taxpayer.
If a pension contribution helps to restore other allowances, the effective rate of relief can be as high as 60%.
- Reducing tax rates and reinstating allowances
Making a pension contribution, whether as a personal contribution or an employer contribution through salary sacrifice, can reduce tax rates paid on total income, either from 45% to 40% or from 40% to 20%. ‘Adjusted net income’ (ANI) is also reduced. This can help to reinstate personal allowances (worth £5,000 to a higher rate taxpayer) or child benefit.
- Pension funding by salary sacrifice (or not)
Individuals may be able to sacrifice part of a redundancy payment in favour of an employer pension contribution. Employer pension contributions are not normally subject to NI at 13.8% but statutory redundancy payments in excess of £30,000 are. This means employers will make savings from the sacrifice agreement, which they may be willing to pass on to the individual. Care should be taken to ensure that the sacrifice is made from parts of the redundancy package that are subject to employers NI in the first place.
High earners should take further care here as this option can cause the pensions annual allowance to be tapered. This restricts the amount that can be paid into pension without incurring a pensions annual allowance tax charge. For these individuals, a personal pension may be more appropriate.
The thought of redundancy is scary and unsettling. However, it can be a welcome cash injection that could mean retirement plans can be brought forward or savings boosted if new employment is found quickly. The silver lining may indeed mean that with careful planning, retirement and savings plans could be progressed more quickly.