How to make the most of a redundancy payment

When we talk about stealth taxes and frozen allowances, we tend to think about income tax or the nil rate band for inheritance tax.

But one lesser mentioned allowance that has been frozen for decades is the amount of redundancy pay you can receive tax free. It has held steadfast at £30,000 since 1989 and has not been uprated in 36 years.

Had that allowance increased in line with rising costs, it would now stand close to £80,000.

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

“The failure to adjust this limit means that more redundancy payments are now subject to tax than in previous decades,” says Shaun Moore, a tax and financial planning expert at Quilter, “particularly for long-serving or senior employees receiving enhanced packages.”

The tax-free redundancy payment provides a valuable safety net if you do lose your job and means you get to keep more of that crucial final pay cheque. That money, after all, will need to keep you going until you start earning again – or provide “bridging funds” until you retire and are able to start taking pension benefits.

However, if you’re fortunate enough to be in a solid position financially (for example, you can get by on your partner’s earnings) or you find a new job relatively quickly, your redundancy payment could provide something of a silver lining and help secure your financial future – in spite of the frozen allowance.

In fact, if you’re prepared to invest for the long term, you may even be able to claim back your tax.

Moore says: “Once you’re back in employment and your financial position stabilises, any unspent redundancy money can be a powerful tool for long-term planning. The best use of these funds depends on your personal goals and financial priorities.”

• Seven tips to give your money a 30-minute summer makeover
• Premium bonds: my financial guilty pleasure

If you really land on feet and secure a new job very quickly, the tax-free status of your redundancy payment shouldn’t be affected. However, Moore stresses that timing matters.

 “If you accept a new role with the same employer or a connected company before your termination date, HMRC may view the redundancy as invalid, potentially removing the tax exemption,” he explains.

“It’s also worth reviewing your employment contract and any settlement agreement to ensure there are no clauses that could affect your entitlement. Seeking legal or tax advice before signing a new contract can help avoid unintended consequences.”

Putting your redundancy payment to good use

If you can’t wait to be mortgage free, it may be worth considering paying some of it off with your redundancy payment.

Most mortgage lenders will let you overpay your mortgage by a typical 10% of your outstanding balance each year, without you incurring any penalty charges. So long as you instruct your lender to keep your repayments at their existing level, you could knock years off your mortgage term and save thousands of pounds in interest.

You just need to bear in mind that, unless you use an offset mortgage, you won’t be able to access your lump sum if you need it (without remortgaging or selling up).

Another option – that doesn’t involve tying up your funds in quite the same way – is to consider investing it for long-term growth in a stocks and shares individual savings account (ISA). Each year you can pay up to £20,000 into ISAs and there will no tax to pay at all on dividends or capital gains.

To increase your chances of growing your money, it’s normally recommended that you don’t invest money that you are likely to need within the next five to 10 years. However, with an ISA, it is possible to access your money whenever you wish.

Boosting your pension

An even more tax-efficient play, however, could be to boost your retirement savings by paying money into your pension.

The rules around redundancy and pension contributions are, admittedly, confusing, but the benefits mean it’s worth getting your head around them.

It’s not possible to pay the first £30,000 tax-free portion of your redundancy payment into your pension. This is because it doesn’t count as “relevant earnings” for pension contributions.

However, some components of your overall settlement that may be paid in addition to your actual redundancy payment do count as earnings, meaning they can be paid into your pension. This would include taxable payments such as salary, holiday pay, bonuses or payments in lieu of notice.

However, if your actual redundancy payment is over £30,000, you can pay the taxable surplus into your pension and get tax relief on your contribution.

Tax relief on pension contributions is equivalent to the highest rate of income tax that you pay and effectively means that you get the tax that will have been deducted from your payment back.

As a result, it means it only “costs” a higher-rate taxpayer £6,000 to pay a £10,000 lump sum into their pension.

The most tax-effective way to pay redundancy cash into your pension is to be super organised and get your employer to do it on your behalf as part of your settlement.

“This is known as an ‘employer contribution’ and can be highly tax-efficient, as it avoids both income tax and national insurance,” explains Moore. In some cases, generous employers may even pass on their national insurance (NI) saving too.

• Your life is moving on, but is your pension keeping up?
• Sign up to our free newsletter for share, fund and trust ideas, and the latest news and analysis

If you’re not ready to commit money to your pension that quickly, you can still pay money into your pension yourself at a later date. This could be into your workplace pension, or a standalone personal pension such as a self-invested personal pension (SIPP).

The key, however, if you’re making a personal contribution, is to ensure you get the full rate of tax relief that you’re entitled to. Depending on your pension, you may only get basic-rate tax relief applied automatically. If you pay higher or additional rate tax you will likely need to declare your contribution on your annual tax return, to claim your outstanding relief.

You do just need to be mindful of your overall allowance for pensions – especially if you have a lower income for the year due to an extended spell out of work.

Each year the amount you can pay in and get tax relief on is capped at 100% of your earnings, up to a maximum of £60,000.

However, while paying a redundancy payment into your pension is arguably the most tax-effective way to use the money, it does mean you won’t be able to access it until you reach age 55 (increasing to 57 in 2028).

As such, this route is likely to be more appealing to those who are already in the late 40s or early 50s and won’t need to wait long before they can access their pot.

Covering the basics first

Paying your redundancy payment into your mortgage, an ISA, or your pension, are all sensible choices.

But, before you make any major investments, it’s important to cover the basics first and ensure you have a readily accessible emergency savings pot. Experts typically recommend holding three to six months’ expenses in cash for a rainy day – and if you’ve just had a spell of time without a job, you might need to top yours up.

If you are unsure about the best way to use a significant redundancy payment, it’s worth consulting a regulated financial planner.