The UK tax treatment of termination payments under ITEPA 2003 splits every leaving package into separate components, and each component is taxed on its own rules. Contractual amounts and a calculated slice of notice pay are taxed as salary. The genuine compensation portion gets a £30,000 Income Tax and National Insurance exemption. A few items, including employer pension contributions and payments for injury or disability, sit outside the tax net entirely. Working out what you actually keep depends on getting each element into the right bucket.
Contractual Pay Is Taxed as Salary
Anything your contract already entitles you to is earnings under Section 62 of ITEPA 2003 and goes through PAYE with full Income Tax and Class 1 National Insurance deducted.1Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 62 – Earnings That covers outstanding wages, accrued but untaken holiday, bonuses you’d already earned, and contractual pay in lieu of notice where the contract permits your employer to pay you off rather than keep you at work through your notice period.
No relief applies to these amounts. If the contract says you’re owed it, you pay tax on all of it at your marginal rate, and employee NICs come off as well. Employee NICs for 2026–27 are 8% on weekly earnings between £242 and £967 and 2% above that.2GOV.UK. National Insurance rates and categories
Post-Employment Notice Pay Is Stripped Out Automatically
Even if your settlement agreement calls the entire lump sum “compensation for loss of office,” Section 402D of ITEPA 2003 forces a calculation that reclassifies any unworked notice period as taxable pay.3HM Revenue & Customs. EIM13880 – Post-employment notice pay (PENP) formula The Post-Employment Notice Pay (PENP) figure that comes out of the formula is taxed through PAYE with Income Tax and Class 1 NICs, exactly like salary. Only what remains after PENP has been carved off can potentially benefit from the £30,000 exemption.
The formula is ((BP × D) ÷ P) − T, where BP is your basic pay for the last pay period before notice was given, D is the number of calendar days in your unworked notice period, P is the number of calendar days in that pay period, and T is any termination payment already taxed as earnings (such as a contractual PILON). A negative result is treated as nil, and PENP cannot exceed the total termination award.3HM Revenue & Customs. EIM13880 – Post-employment notice pay (PENP) formula
The higher your salary and the longer your unworked notice, the more the formula captures. On £6,000 a month with three months of unworked notice, roughly £18,000 gets reclassified as taxable pay before the £30,000 threshold is even in the picture. Employers must apply this calculation to every non-contractual termination payment; skipping it just stores up an underpayment for HMRC to collect later.
The £30,000 Tax-Free Threshold
Once contractual pay and PENP have been separated out, the remaining genuine termination payment falls under Sections 401 and 403 of ITEPA 2003, and the first £30,000 is exempt from both Income Tax and NICs.4Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 403 Statutory redundancy pay, enhanced redundancy pay, and ex gratia goodwill payments for loss of the job all qualify.
For dismissals on or after 6 April 2026, the statutory redundancy weekly pay cap is £751, and the maximum statutory redundancy payment is £22,530.5GOV.UK. Redundancy: your rights – Statutory redundancy pay That sits comfortably inside the exemption, and an employer top-up remains covered until the combined figure passes £30,000.
The £30,000 is not a per-payment allowance. It aggregates across all termination-related payments from the same employment or related employments.6HM Revenue & Customs. EIM13505 – Termination payments and benefits: section 401 ITEPA 2003 Take a £20,000 redundancy payment now and settle a linked claim for another £25,000 later, and only £10,000 of that second payment is tax-free.
What Happens Above £30,000
Amounts qualifying for Section 403 treatment that exceed £30,000 are subject to Income Tax at your marginal rate, but no employee Class 1 NICs. The employer pays Class 1A NICs on the excess at 15% for 2026–27.7GOV.UK. Rates and thresholds for employers 2026 to 2027 That employer cost frequently comes into play in settlement talks, because it raises the true price of any offer above the threshold.
Redirect Part of the Payment Into a Pension
The most effective way to reduce the tax bill on a termination payment is to have your employer pay part of it directly into a registered pension scheme. Employer contributions made as part of a termination arrangement are exempt from Income Tax and NICs, provided they stay within the pension annual allowance (currently £60,000 for most people, tapered for high earners).8GOV.UK. Termination payments and tax when you leave a job
The contribution sits outside both PENP and the £30,000 threshold. Redirect £20,000 of a £50,000 termination payment into your pension, and only £30,000 enters the Section 401 framework. The contribution has to be made by the employer directly to the pension scheme. Pay you first and then have you contribute, and the exemption is gone. Anything above the annual allowance triggers a tax charge on the excess.8GOV.UK. Termination payments and tax when you leave a job
Retraining and Legal Fees
Under Section 311 of ITEPA 2003, retraining or outplacement course costs paid by your employer are exempt from tax if the training is designed to help you find new employment or become self-employed.9HM Revenue & Customs. EIM05005 – Employment income: retraining expenses paid by employer: exemption from tax The course can run up to two years and doesn’t have to be full-time. The exemption applies only to what the employer pays directly, not to courses you fund yourself.
Legal fees your employer pays for negotiating the settlement agreement are exempt under Section 413A on two conditions: the costs must relate exclusively to the termination, and the payment must go directly to your solicitor under a specific clause in the settlement agreement.10HM Revenue & Customs. EIM13740 – Termination payments and benefits: Section 401 ITEPA 2003 Route the money through you instead, or leave the dedicated clause out, and the exemption fails.
Payments for Injury or Disability
Section 406 of ITEPA 2003 gives a full, uncapped exemption for payments made on account of injury to, or disability of, an employee, provided the condition is genuinely the reason the employment ended.11Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 406 The whole payment is free of Income Tax and NICs.
The statute is explicit that “injury” includes psychiatric injury but does not include injured feelings.11Legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 406 That line matters in discrimination cases. A hurt feelings award in a harassment claim is not exempt. If the same harassment caused a diagnosed psychiatric condition that made continuing in the role impossible, the payment tied to that condition can qualify. HMRC expects medical evidence from a qualified professional showing the impairment and its causal link to the termination.
Restrictive Covenant Payments Are a Trap
If any part of the settlement is paid in return for you agreeing to a new post-employment restriction such as a non-compete or non-solicitation clause, Section 225 of ITEPA 2003 treats that portion as taxable earnings in full for the year you receive it.12HM Revenue & Customs. EIM03602 – Restrictive covenants: consideration taxable as general earnings HMRC can look behind the label the agreement puts on it. Lumping the covenant payment into a general “compensation” heading does not save the tax; keeping it separately identified in the drafting protects the treatment of the rest of the package.
Scottish Rates and Foreign Service
Scottish taxpayers face different Income Tax rates on the taxable elements of a termination payment. For 2026–27 the Scottish bands run in six tiers from a 19% starter rate up to a 48% top rate on income above £125,140.13gov.scot. Scottish Income Tax 2026 to 2027: technical factsheet National Insurance rates are UK-wide. If you live in Scotland and you’re negotiating a large package, run the numbers on Scottish rates from the start.
Employees who spent significant time working abroad may qualify for Foreign Service Relief under Section 413, which reduces the taxable part of a termination payment in proportion to time spent overseas. It is only available if you are non-UK resident in the tax year employment ends. If 75% or more of your total service qualifies as foreign service, the whole termination payment is exempt. Below that, the taxable amount is reduced by the ratio of foreign service days to total service days, and the reduction applies to both PENP and the Section 403 charge above £30,000.14HM Revenue & Customs. EIM13985 – Termination payments and benefits: example: foreign service reduction
Reporting and Penalties
Your employer handles the mechanics through PAYE. Contractual pay and PENP go through as normal pay. Amounts above £30,000 have Income Tax deducted through payroll but no employee NICs; the employer separately settles Class 1A NICs on the excess.
If your total termination payment exceeds £30,000, or you receive multiple linked payments that together cross the threshold, the details go on your Self Assessment return. Getting it wrong triggers inaccuracy penalties on top of the unpaid tax and interest:15GOV.UK. Penalties: an overview for agents and advisers
- Careless error: up to 30% of the tax owed
- Deliberate error: 20% to 70%
- Deliberate and concealed: 30% to 100%
HMRC reduces those percentages for voluntary disclosure and cooperation. Given that the department can look back several years, misclassifying elements of a termination package tends to cost more than doing it correctly the first time.