Settlement agreement payments are not automatically tax-free — the tax treatment depends on what each element of the payment represents. Compensation for job loss is tax-free up to £30,000, but pay in lieu of notice, unpaid wages, and bonuses are always taxable. Here is how to work out your position in 2026/27.
The Two Categories of Settlement Payment
| Payment type | Taxable? | NI? | Notes |
|---|---|---|---|
| Compensation for loss of employment (ex gratia) | First £30,000 tax-free | No NI up to £30,000 | Genuine goodwill payment |
| Statutory redundancy pay | First £30,000 tax-free | No NI | Counts towards £30,000 limit |
| Pay in lieu of notice (PILON) | Fully taxable | Yes (employee NI) | PENP rules since April 2018 |
| Unpaid wages / accrued salary | Fully taxable | Yes | These were always earnings |
| Holiday pay owed | Fully taxable | Yes | Accrued entitlement, not compensation |
| Bonus due under contract | Fully taxable | Yes | Earned, not discretionary compensation |
| Legal costs paid to your solicitor | Tax-free | No | If paid direct to solicitor’s firm |
| Injury to feelings / personal injury | Often tax-free | No | Complex — depends on nature of claim |
The £30,000 Exemption — How It Works
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 NI.
What counts towards the £30,000 limit:
- Statutory redundancy pay
- Ex gratia payments for loss of office
- Enhanced redundancy pay (above statutory)
- Payments from employer-funded PILON clauses that existed before April 2018 (rare)
What does NOT count towards the £30,000 limit:
- PILON (calculated separately under PENP rules)
- Accrued wages, holiday pay, or bonus
Amounts above £30,000 are taxed at your marginal rate. Employer NI (Class 1A at 15%) also applies to amounts above £30,000 — the employer pays this, not you.
Worked Example: Mark’s Settlement Agreement
Mark is made redundant at 45. He earns £50,000 per year. His settlement agreement includes:
| Component | Amount | Tax treatment |
|---|---|---|
| Statutory redundancy pay | £9,900 | Tax-free (within £30,000) |
| Enhanced ex gratia payment | £20,100 | Tax-free (total reaches £30,000) |
| PILON (3 months’ notice) | £12,500 | Fully taxable — Income Tax + NI |
| Outstanding holiday pay | £2,600 | Fully taxable — Income Tax + NI |
| Total received | £45,100 |
Mark’s taxable income from the settlement: £12,500 + £2,600 = £15,100
If Mark was a higher rate taxpayer (salary above £37,700 threshold), tax on the taxable element would be approximately £6,040.
Post-Employment Notice Pay (PENP) — The PILON Rules
Since April 2018, HMRC uses the PENP formula to calculate how much of any termination lump sum represents notice pay — even if no formal PILON clause exists in the contract.
The PENP formula: $$\text{PENP} = \left(\frac{\text{Basic Pay} \times \text{Post-Employment Notice Period (days)}}{\text{Days in pay period}}\right) - \text{Contractual PILON paid}$$
In practice, PENP means: any payment that covers the notice period you did not work is taxed as earnings. Your employer is responsible for calculating and withholding the correct PAYE and NI under PENP.
Legal Costs and Injury to Feelings
Legal costs: If your employer pays your solicitor’s fees directly to the solicitor’s firm, these are tax-free under ITEPA 2003 s.413A. If the money is paid to you first, it may be treated as income.
Injury to feelings / discrimination claims: Payments that are genuinely for injury to feelings (rather than loss of employment) may fall outside the £30,000 limit entirely — as compensation for a wrong, not termination pay. This area is complex and fact-specific; specialist employment tax advice is recommended for substantial discrimination settlements.
Key Figures 2026/27
| Amount | |
|---|---|
| Tax-free termination payment threshold | £30,000 |
| Employer NI (Class 1A) on excess above £30,000 | 15% |
| Basic rate Income Tax on taxable excess | 20% |
| Higher rate Income Tax on taxable excess | 40% |
| Statutory weekly redundancy cap | £700/week |
| Statutory redundancy maximum (20 years, age 41+) | £21,000 |
Negotiating the Tax Treatment in Your Settlement
When negotiating a settlement agreement, the split between elements matters. Maximising the ex gratia (compensation) element and minimising contractual PILON can reduce the taxable portion — subject to genuine commercial justification. Your settlement agreement should specify clearly what each payment represents.
All settlement agreements must be signed by a qualified solicitor, ACAS conciliator, or trade union representative to be legally binding.
See our redundancy tax guide, income tax rates 2026/27, and Self Assessment guide.