Key rule: The first £30,000 of a qualifying termination payment is exempt from income tax. But PILON (payment in lieu of notice) is always taxable — no exceptions. Getting these categories right matters enormously.
The basic rule: section 403 ITEPA 2003
Under section 403 of the Income Tax (Earnings and Pensions) Act 2003, the first £30,000 of a termination payment is exempt from income tax. This has been the rule since 1988 and the threshold has not increased in decades — meaning it covers a smaller proportion of typical settlements every year.
Importantly, this exemption applies to income tax only. National Insurance contributions on the excess (above £30,000) are also payable at 2% — for both employee and employer — following changes introduced in April 2020.
What qualifies for the £30,000 exemption?
The following types of payment can be included within the £30,000 tax-free pool:
- Statutory redundancy pay — always qualifies
- Enhanced redundancy pay — qualifies up to the £30,000 combined limit
- Ex-gratia payments — payments made without any contractual obligation, as compensation for loss of employment
- Compensation for loss of office — genuine compensation (not pay for work done)
- Some injury to feelings awards — where they relate to a non-employment matter (complex area — get advice)
What does NOT qualify — always taxable
The following are always subject to income tax and NI regardless of the £30,000 exemption:
- Payment in lieu of notice (PILON) — see below for the critical change in 2018
- Holiday pay — accrued holiday is earnings, always taxable
- Salary or wages owed — any arrears of pay are earnings
- Bonus payments — contractual bonuses are earnings
- Payments for restrictive covenants — always taxable as employment income
- Benefits in kind — continued use of a company car, for example
The 2018 PILON rule change — critical
Before April 2018, whether PILON was taxable depended on whether there was a contractual PILON clause. Without a clause, a payment in lieu of notice was sometimes treated as damages (tax-free within the £30,000 limit).
This changed completely in April 2018. Now, all PILON payments are treated as taxable earnings regardless of whether a PILON clause exists in the contract. HMRC introduced the concept of "Post-Employment Notice Pay" (PENP), which calculates the taxable element of any payment that relates to an unworked notice period.
This is one of the most commonly misunderstood areas of settlement agreement tax — do not assume any element of notice pay is tax-free.
How the £30,000 limit applies in practice
The exemption applies to the total of all qualifying payments, not per payment type. Example:
| Payment type | Amount | Tax treatment |
|---|---|---|
| Notice pay (PILON) | £12,000 | Fully taxable as earnings |
| Statutory redundancy pay | £8,500 | Tax-free (within £30k pool) |
| Ex-gratia payment | £25,000 | £21,500 tax-free, £3,500 taxable (pool used up) |
| Holiday pay | £1,800 | Fully taxable as earnings |
| Total | £47,300 | £30,000 tax-free, £17,300 taxable |
Can you increase the tax-free element?
There are legitimate ways to structure a settlement to maximise the tax-free amount:
1. Pension contributions
Employer contributions to your pension scheme from a settlement payment are generally not subject to income tax and NI (subject to annual allowance limits). This can be highly tax-efficient for higher earners. Requires agreement from the employer and must be structured correctly.
2. Correct categorisation
Ensuring payments are correctly categorised in the agreement matters. An experienced solicitor will review the structure to ensure the maximum qualifying amounts sit within the tax-free pool.
3. Avoiding contractual payments in the termination payment
Payments that the employer was already contractually obliged to make (like an accrued bonus) should not be labelled as part of the settlement's ex-gratia element — they are taxable regardless, and conflating them can create compliance issues.
Calculate your tax position
Use our Settlement Tax Calculator to model the tax treatment of your specific settlement. Or use the Settlement Agreement Calculator for a full breakdown including estimated tax.
NI on termination payments
Since April 2020, employers must pay Class 1A NI at 13.8% on termination payments above £30,000. Employees pay 2% employee NI on the excess above £30,000. This makes very large settlement payments somewhat less generous in net terms for both parties, and may affect negotiation dynamics.