Nigel Orange, technical support manager (pensions) at Canada Life, offers tips on how to help clients make the most of redundancy payments.
Regrettably, the economic climate over the past few years has led to employers cutting costs and this, in turn, has led to an increasing amount of workforce redundancies.
Redundancy or severance pay for some individuals can be the largest single payment of money ever received, so it is important that guidance is available on all options and what can be done to make any package as tax efficient as possible.
Pension contributions and tax relief
The tax situation might be more acceptable if a pension contribution was made. Tax relief is available for pension contributions based on the higher amount of £3,600 per annum or 100% of relevant UK earnings up to the annual allowance for that tax year.
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For the purposes of registered pension schemes, “relevant UK earnings” is defined as employment income (for example, salary, wages, bonus, overtime) as long as it is chargeable to tax under section 7(2) of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). This includes taxable termination payments (above the £30,000 threshold) as these are defined as employment income under section 403(1) of ITEPA 2003.
Redundancy packages and taxation
Redundancy payments are treated as earned income from employment except for the first £30,000, which is tax free. The excess of any payment will be added to any other earned income and, as soon as income exceeds £42,475, higher rate tax of 40% is payable. This can have a significant impact on the overall amount of tax paid on a redundancy package depending on individual personal circumstances.
A small tip – if your client is a higher rate taxpayer, try to make sure any severance is paid after they receive their P45 and not before: this way anything over £30,000 will be taxed at just 20% initially and they will have a further year to pay any higher rate tax owed.
To examine the potential amount of tax payable from a redundancy package, take an example of someone receiving a redundancy payment of £70,000. Let us assume they have earned income up to the date of redundancy of £75,000. In this instance, after deducting the £30,000 tax-free element, their taxable income would increase to £115,000.
An amount of £115,000 is significant. Why? Because as soon as income exceeds £100,000 then tax-free personal allowance (PA), currently £8,105, is gradually withdrawn. The total PA is lost once income reaches £116,210 on the basis that every £2 over the limit £1 is lost. So in this scenario, the individual would only retain £605 of their overall tax-free PA.
What would the tax bill be with and without a pension contribution?
If the example redundancy package were to be taken in full, with no pension contribution, then the first £605 (PA) would be tax free, the next £34,370 taxed at 20%, then £80,025 taxed at 40%, resulting in a total tax bill of £38,884. The overall net amount received would be £106,116.
If, however, the excess payment of £40,000 is paid as a pension contribution then the total earned income would remain at £75,000.
So, in the same example £8,105 (PA) is tax free, the next £34,370 is taxed at 20%, then £32,525 is taxed at 40%, resulting in a total tax bill of £19,884 and a saving of £19,000. The overall net amount received would be £85,116 with £40,000 in the pension fund: a total of £125,116.
If redundancy were to take place after the age of 55 and should the individual be desperate for capital or income, the pension fund is available to provide a 25% tax-free cash element or income, or both.
What happens if the pension contribution exceeds the annual allowance (AA)?
It is important not to forget the AA when working out how much of a pension contribution can be made. The government has specifically confirmed that redundancy payments used as pension contributions are not exempt from the AA, as employers are expected to agree alternative remuneration arrangements in such cases.
It is also worth remembering that in the Autumn Statement the chancellor announced a significant reduction in the AA - from £50,000 to £40,000, effective from April 2013. However, providing the individual is a member of a UK registered pension scheme and they are making full use of the current AA, they can carry forward any unused AA from their pension input periods ending in the three previous tax years.
This is particularly useful in these circumstances but remember that contributions still remain capped at 100% of net relevant earnings for the purpose of receiving tax relief during the current tax year. What they have earned in previous tax years is irrelevant.
In addition, an employer, rather than pay all the excess over £30,000 to an employee who will be taxed on it, may instead agree to make a payment to the employee’s pension plan, and offset the contribution against the company profits. For the purpose of determining its corporation tax liability, HMRC would not in this instance conduct the ”wholly and exclusively” test.
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