When an employee leaves a job, they may receive a termination package from their employer. However, not all termination payments are taxed in the same way.
Understanding the difference can help both employers and employees avoid unexpected tax bills.
What Is a Termination Payment?
A termination payment is compensation paid when employment comes to an end. Common examples include:
- Redundancy payments
- Compensation for loss of employment
- Ex-gratia (goodwill) payments
- Damages for dismissal
- Certain retirement-related payments
The tax treatment depends on the nature of the payment.
The Key Question: Is It Earnings or Compensation?
The first step is to determine whether the payment is:
- Earnings from employment, or
- Compensation for the loss of employment
If a payment is something the employee is entitled to under their contract, it is usually treated as earnings and taxed in full.
Examples include:
- Salary
- Bonuses
- Commission
- Contractual notice payments
These payments do not qualify for any tax-free exemption.
What Is an Ex-Gratia Payment?
An ex-gratia payment is a voluntary payment made by an employer when there is no contractual obligation to make it.
These payments are often made as part of a settlement agreement or as compensation for loss of employment.
In many cases, ex-gratia payments can benefit from the £30,000 tax-free exemption.
The £30,000 Tax-Free Exemption
One of the most valuable tax reliefs available on termination is the £30,000 exemption.
In simple terms:
- The first £30,000 of a qualifying termination payment is tax-free.
- Any amount above £30,000 is taxable.
For example:
An employee receives an ex-gratia termination payment of £50,000.
- First £30,000: Tax-free
- Remaining £20,000: Taxable
This exemption typically applies to:
- Genuine redundancy payments
- Ex-gratia compensation payments
- Compensation for loss of office
It does not apply to normal earnings or contractual payments.
Can the Exemption Be Used More Than Once?
No.
If multiple termination payments are made in relation to the same employment, the £30,000 exemption applies to the total package rather than to each payment individually.
Payments That May Be Fully Tax-Free
Some termination-related payments can be completely exempt from tax.
Examples include:
Death Benefits
Payments made because an employee has died are generally tax-free.
Injury or Disability Compensation
Compensation paid because an employee can no longer perform their duties due to a genuine injury or disability may be exempt.
However, compensation for “hurt feelings” alone does not qualify.
Pension Contributions
Employers sometimes contribute directly into a pension as part of a termination package.
These contributions can often be made tax efficiently and are frequently used during settlement negotiations.
What About Retirement Payments?
Special care is needed where a payment is made because an employee is retiring.
In some circumstances, HMRC may treat retirement-related payments differently from normal termination compensation, potentially resulting in a less favourable tax outcome.
It is therefore important to obtain professional advice when retirement forms part of a termination arrangement.
Final Thoughts
The tax treatment of termination payments depends on what the payment is intended to compensate.
A genuine compensation payment may qualify for the valuable £30,000 tax-free exemption, while contractual payments and earnings are usually fully taxable.
Before agreeing a termination package, both employers and employees should ensure they understand exactly how each element will be taxed.
