This guide is for financial advisers only. It mustn’t be distributed to, or relied on by, customers. It is based on our understanding of legislation as at May 2023.
For many employees, losing their job may cause uncertainty and financial hardship but for others it may bring an opportunity to use some or all of any redundancy payment received as an investment opportunity. This guide looks specifically at using a redundancy payment to make an employer or personal contribution to help increase pension savings.
An employee who has worked for their employer continuously for two years or more who is dismissed for reasons of redundancy, is normally entitled to statutory redundancy pay, which is the minimum they are entitled to by law. The amount depends on the employee’s length of employment, age and weekly pay. Details of the rates of pay can be found on the gov.uk website and there’s also a calculator available to work out statutory redundancy pay too. If an employer becomes insolvent, and an employee is made redundant as a result of this, it’s possible for the employee to receive statutory redundancy pay from the government via the Redundancy Payments Service.
In practice, many employees, including public sector workers, have a right to contractual redundancy pay that gives them better rights than the statutory minimum. This would entitle them to extra redundancy pay on top of the statutory minimum.
It’s worth pointing out that an employee may receive several different payments when being made redundant from their employer. As well as redundancy pay for the loss of their job, an employee may also be due a final payment of their normal salary including any bonus accrued or overtime due, a payment in lieu of notice (PILON) and/or holiday pay. All due employer and employee pension contributions should also be paid to the workplace pension scheme operated by the employer.
Some employees may be required to continue working during their notice period, whereas others may be put on garden leave or be allowed to leave earlier than the date their notice period ends. Garden leave would typically involve an employee still being employed during their notice period and although they shouldn’t need to become involved in work, they should be available to do so if required. During garden leave, it wouldn’t be possible for an employee to start working elsewhere as they are still contracted to work for their existing employer. In contrast, the PILON option involves an employee’s role being terminated immediately, and they are paid what they are due as notice pay. Once employment has been terminated, it’s possible for the employee to start another role elsewhere.
Up to £30,000 of redundancy pay is tax-free and isn’t regarded as earned income by HMRC. This means statutory redundancy pay is completely free of tax as the maximum statutory limit is below the £30,000 threshold. Any part of a contractual redundancy payment that exceeds the £30,000 tax-free element is subject to income tax under PAYE. There are no employee National Insurance contributions (NICs) payable on any redundancy pay, whether it’s above or below the £30,000 tax-free limit. The correct amount of tax may not be deducted from the redundancy pay paid to an employee, so there may be a need to reclaim overpaid tax or to pay an additional amount of tax if there’s been an underpayment.
Any amounts paid in addition to redundancy pay are likely to be subject to tax and NICs - this could include salary, bonuses, overtime, a PILON and holiday pay. As part of the redundancy process, an employer should provide an employee with a breakdown of the payments due, and this should show the amounts that are and aren’t subject to tax and NICs.
Tax relief on personal contributions to a registered pension scheme in the UK is limited to 100% of an individual’s relevant UK earnings in a tax year or £3,600 gross pa, if higher. The taxable element of redundancy pay (that is, any amount above £30,000) counts as relevant UK earnings, as will any payments made for salary, bonus, overtime and a PILON, so there can be scope to use some or all of a redundancy payment above the tax-free amount to make a personal contribution.
If the planned contribution is above the annual allowance (either the standard £60,000 annual allowance or the tapered annual allowance if an employee is a high earner in the tax year), it’s possible to use carry forward to avoid triggering an annual allowance charge. Carry forward makes use of any unused annual allowance from the previous three tax years, with the earliest of the three tax years being used first. If an employee was subject to the tapered annual allowance in a previous tax year, the carry forward available for that year is based on the tapered annual allowance rather than the standard annual allowance.
Example
Catherine is 50 years old and lives in England. She was the manager for a public relations agency before being made redundant, and she has received redundancy pay of £70,000.
Income tax due = (£70,000 - £30,000) x 40% = £16,000.
The net redundancy pay Catherine would receive is £54,000.
Catherine doesn’t need her redundancy pay to meet her immediate financial needs, so decides to make a gross pension contribution of £40,000 into a personal pension. This is equal to the taxable element of her redundancy pay.
The net contribution due is £32,000 taking account of basic rate tax relief of 20%. By making this net pension contribution and then claiming the additional 20% tax relief through her tax return, Catherine receives 40% tax relief (a total of £16,000) on her contribution. She has been able to offset in the full the income tax deducted from her redundancy pay.
This assumes that Catherine is a higher rate taxpayer and higher rate tax relief is available on the whole pension contribution she makes. It also assumes that Catherine is subject to the standard annual allowance of £60,000 in the tax year she is made redundant.
As a gross contribution of £40,000 has been invested into Catherine’s personal pension, she will need to have relevant UK earnings of at least that amount in the tax year to justify the contribution for tax relief purposes.
An employer and employee could agree that, instead of receiving the full redundancy payment, some or all of the taxable element is paid directly into a pension arrangement as an employer contribution. This would need to be agreed before the redundancy pay became due (for example, before the cut-off date for it to be paid to the employee). The terms of the redundancy agreement would need to allow this to happen, and the employer could claim corporation tax relief on the contribution subject to the usual ‘wholly and exclusively’ rules.
Using the example above, Catherine could agree with her employer to be paid tax-free redundancy pay of £30,000 with a £40,000 employer contribution being made direct into her personal pension. As employer NICs are payable on any element of a contractual redundancy payment exceeding £30,000, It’s possible for the contribution to be increased further should the employer agree to add in any of their employer NICs saving. It may also be also possible, if the employer contribution is over the annual allowance or tapered annual allowance, to use carry forward, in the same way as for a personal contribution.
If an employee is subject to the tapered annual allowance in the tax year they are made redundant, payment of a personal contribution or an employer contribution will count differently when assessing adjusted and threshold income for calculating the tapered annual allowance. It’s worth bearing this in mind when assessing whether a personal or employer contribution is made. How adjusted and threshold income are calculated is explained in our Tapered Annual Allowance guide.