Scope: For UK employees receiving a payment when employment ends. The label on a settlement agreement does not by itself determine the tax treatment.
The short answer
Break the package into components. Unpaid wages, holiday pay, bonuses, restrictive-covenant payments and pay for a notice period are earnings, so tax and employee National Insurance normally apply.
The first combined £30,000 of qualifying statutory redundancy pay, additional severance and relevant non-cash benefits is usually free of Income Tax. This does not mean the first £30,000 of every leaving payment is tax-free.
Qualifying termination amounts above the combined threshold are taxable, and the employer pays Class 1A National Insurance on the qualifying excess.
Separate earnings from termination compensation
Create a table from the settlement statement showing:
- salary and unpaid wages;
- accrued holiday pay;
- bonus or commission;
- payment in lieu of notice;
- statutory redundancy pay;
- enhanced severance;
- restrictive-covenant payment;
- retained assets or non-cash benefits;
- pension contribution; and
- employer-paid legal costs.
Earnings remain earnings because they are paid on departure. The special termination threshold applies only after amounts taxed under the ordinary earnings rules and the notice-pay rules have been identified.
Notice pay and PENP
Payment in lieu of notice is normally subject to tax and National Insurance. HMRC’s rules can also identify post-employment notice pay, or PENP, within a severance package where the employee did not work the full notice period. The employer calculates this amount.
That is why a settlement described as “compensation” can still contain taxable earnings. Obtain the employer’s component breakdown and PENP calculation rather than applying £30,000 to the package total.
What may fall within the £30,000 threshold
HMRC says the first combined £30,000 of statutory redundancy pay, additional severance or enhanced redundancy, and relevant non-cash benefits is usually not taxed. Amounts are aggregated for the threshold. Tax applies to the qualifying excess.
Employer contributions to a registered pension scheme and legal costs paid directly to the employee’s solicitor have separate treatment in HMRC’s guidance. Injury, illness or disability payments also have specific conditions. Do not assume an exemption without matching the exact facts.
How deductions are made
The employer processes taxable components through payroll and deducts Income Tax and any employee National Insurance due. If a termination payment is made after the P45 has been issued, HMRC says the employer uses code 0T, which assumes no Personal Allowance for that payment.
An 0T deduction may not equal the final annual liability. Total income, other pay and allowances across the full tax year can produce an overpayment or underpayment when HMRC reconciles the year. If you file Self Assessment, HMRC says to include the termination payment in the additional-information area.
Worked structure, not a personal calculation
Suppose a package contains £4,000 holiday pay, £6,000 notice pay and £35,000 qualifying severance. The £10,000 earnings element is considered under normal tax and National Insurance rules. The severance element is then considered separately: subject to the detailed rules, £30,000 may fall within the termination threshold and £5,000 may be taxable.
This example deliberately ignores annual income, code, pension treatment and other facts. It shows the ordering, not the final deduction.
Documents to keep
- settlement agreement and redundancy calculation;
- itemised payroll breakdown;
- PENP calculation;
- final payslip and P45;
- legal-fee and pension-payment evidence;
- correspondence explaining non-cash benefits; and
- any HMRC reconciliation or return entry.
Common mistakes
- Applying £30,000 to salary, holiday pay or notice pay.
- Looking only at the net settlement figure.
- Ignoring non-cash benefits retained on departure.
- Assuming no employee National Insurance means no employer Class 1A charge.
- Treating the 0T deduction as the final tax result.
- Omitting the payment from a required Self Assessment return.
What to do next
- Obtain an itemised package breakdown.
- Identify ordinary earnings and notice pay first.
- Apply the termination rules only to the remaining qualifying components.
- Check the final payslip and P45.
- Reconcile the full-year PAYE position with HMRC.
- Preserve all supporting documents.