When an employee leaves a business, employers often focus on the amount being paid. However, understanding the tax and National Insurance treatment is equally important.
Two areas that regularly cause confusion are notice pay and redundancy payments.
Notice Periods and Notice Pay
Most employment contracts include a notice period.
When employment ends, employers generally have three options:
1. Employee Works Their Notice
The employee continues working until the notice period expires and receives their normal salary.
This is treated as normal earnings and is fully taxable.
2. Garden Leave
The employee remains employed and continues to receive salary but is not required to work.
Again, this is treated as normal earnings and is fully taxable.
3. Payment in Lieu of Notice (PILON)
The employee leaves immediately and receives compensation instead of working their notice period.
Although many employers assume this can be paid tax-free, this is rarely the case.
Why Notice Pay Is Usually Taxable
HMRC generally regards notice pay as a replacement for salary.
As a result, the amount representing the employee’s unworked notice period is usually treated as earnings and taxed in the same way as normal salary.
This means:
- Income tax applies
- Employee National Insurance applies
- Employer National Insurance applies
Redundancy Payments
Redundancy occurs when a role is no longer required by the business.
A genuine redundancy payment is generally treated more favourably for tax purposes than notice pay.
There are two common types:
- Statutory redundancy payments
- Enhanced redundancy payments offered by employers
Provided the payment is genuinely compensation for redundancy and not disguised earnings, it can usually qualify for the £30,000 tax-free exemption.
National Insurance Treatment
The National Insurance treatment depends on the type of payment being made.
Payments Treated as Earnings
The following are generally subject to both employee and employer National Insurance:
- Salary
- Bonuses
- Contractual termination payments
- Notice pay
Genuine Compensation Payments
Where a payment is a genuine non-contractual compensation payment and qualifies for termination payment treatment:
- Employees do not pay National Insurance.
- Employers may only have an employer National Insurance liability on amounts exceeding £30,000.
This can create a significant saving compared with paying the same amount as salary or bonus.
Non-Cash Benefits
Termination packages do not always consist entirely of cash.
Examples include:
- Company cars transferred to employees
- Continued private medical insurance
- Other employment benefits provided after termination
These benefits can still create tax and National Insurance consequences and should be reviewed carefully before being included in a settlement package.
Outplacement Support and Retraining
Many employers help departing employees move into new roles.
Support such as:
- Career counselling
- CV assistance
- Interview coaching
- Professional retraining
can often be provided in a tax-efficient manner.
This can be a valuable addition to a termination package without increasing the employee’s tax burden.
Final Thoughts
The distinction between compensation for loss of employment and payments that replace salary is critical.
Notice pay is usually taxed in the same way as normal earnings, whereas genuine redundancy and compensation payments may qualify for the £30,000 tax-free exemption.
Because the rules can be complex, employers should review termination packages carefully before making payments to ensure the correct tax and National Insurance treatment is applied.
