Settlement agreements: how much of the payout is tax free?

A settlement agreement ends an employment relationship on agreed terms, usually in exchange for a payment. The headline everyone remembers is that £30,000 is tax free, and the headline is only half true. Here is how a settlement payment is actually built, which parts escape tax and which never do, and why the agreement is not binding without independent legal advice.

What is a settlement agreement?

A settlement agreement is a written contract between employer and employee that brings the employment relationship, or a dispute within it, to a close on agreed terms. In exchange for a payment and usually an agreed reference, the employee waives the right to bring the claims listed in the agreement, such as unfair dismissal or discrimination. It was previously known as a compromise agreement.

It is voluntary on both sides. Nobody is obliged to sign, and an employee who does not sign keeps every right they had before the conversation started.

What is a settlement payment actually made of?

This is the part that decides the tax treatment, and it is why two people receiving “£40,000” can take home very different amounts. A settlement package is a stack of separate elements, each taxed on its own rules.

• Outstanding salary and holiday pay: ordinary earnings, taxed as normal through PAYE.
• Notice pay, or payment in lieu of notice: taxed as earnings, with no shelter available.
• Bonus and commission: earnings, taxed as normal.
• Statutory redundancy pay: qualifies as a termination payment, and counts towards the £30,000.
• Ex gratia compensation for loss of employment: the element the £30,000 exemption is designed for.

How does the £30,000 exemption work?

Under section 401 of the Income Tax (Earnings and Pensions) Act 2003, the first £30,000 of a genuine termination payment is free of both income tax and National Insurance. The word doing the work is “genuine”: the exemption applies to compensation for the loss of the job, not to money the employee had already earned.

Anything above £30,000 in the compensation element is taxed as employment income. Employer National Insurance may also be due on the excess, which is one of the reasons employers care about how the package is structured.

Why can’t notice pay be made tax free?

Because the rules were changed specifically to stop that. Historically, some agreements labelled notice pay as compensation to slide it under the £30,000. The post-employment notice pay rules now require the notice element to be calculated and taxed as earnings regardless of what the agreement calls it. Relabelling achieves nothing except a later argument with HMRC.

The label on a payment does not decide its tax. What the payment is for does.

On what a final payslip should contain more generally, see our explainer on final pay when leaving a job.

Why is independent legal advice compulsory?

Under section 203 of the Employment Rights Act 1996, a settlement agreement is only binding if the employee has received independent legal advice from a qualified, insured adviser, who must be named in the agreement. Without it, the waiver of statutory claims does not hold, which protects the employee and gives the employer the certainty it is paying for.

In practice the employer contributes to the cost, commonly a few hundred pounds, and that contribution is usually enough to cover a straightforward review. The adviser will explain the terms and, just as importantly, give a view on whether the amount offered is reasonable given the claims being waived.

How do you tell whether an offer is fair?

There is no formula, but there is a method. Start from what the employee would receive anyway: notice, accrued holiday, any statutory redundancy entitlement. That is the floor, and it is not compensation at all. Then look at the value of the claims being given up, which depends on the strength of the case, the likely losses and how long a new role would realistically take to find.