Settlement Agreements And Tax Explained (14 August 2026)

The Tax Implications of Settlement Agreements

If you have been offered a settlement agreement, one of the most important practical questions is how much of the payment you will actually keep after tax. Settlement agreement tax treatment is not straightforward, some payments made under a settlement agreement are fully taxable, some qualify for a tax exemption, and others may be paid entirely free of tax.

Understanding the tax implications of a settlement agreement before you sign is essential, and it is one of the reasons why taking independent legal advice is both a legal requirement and a genuine practical benefit.

This guide explains the key rules that determine whether a settlement agreement payment is taxable under UK tax law, how the £30,000 tax exemption works, and which parts of a settlement agreement are always subject to income tax and National Insurance contributions.

The £30,000 Tax Exemption: The Starting Point for Settlement Agreement Tax

The most important rule governing many termination payments is the £30,000 income tax exemption contained in Chapter 3 of Part 6 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). Certain qualifying termination payments can be paid free of income tax up to £30,000. Amounts above £30,000 are generally subject to income tax, and employer Class 1A National Insurance contributions may also be payable on the excess.

The £30,000 exemption does not apply automatically to every payment made under a settlement agreement. It applies only to qualifying termination payments, broadly, payments that are genuinely compensatory and are made in connection with the termination of employment, rather than payments that represent earnings or contractual entitlements. Understanding which parts of the settlement payment fall within the exemption and which are fully taxable is crucial to calculating the net amount you will receive.

Payments That Are Always Fully Taxable

Certain payments made under a settlement agreement are always subject to income tax and National Insurance contributions, regardless of the £30,000 exemption. These include:

Payment in Lieu of Notice (PILON)

Since April 2018, all payments in lieu of notice are fully taxable as earnings, regardless of whether the employment contract contains a PILON clause. HMRC introduced the Post Employment Notice Pay (PENP) rules to ensure that the element of any termination payment that represents notice pay is always subject to income tax and National Insurance contributions. This means that even where a settlement agreement labels a payment as compensation or an ex gratia sum, if part of it represents the notice period the employee would have worked, that element is taxable. The PENP calculation determines how much of the overall settlement payment is treated as notice pay and therefore taxable.

Accrued Holiday Pay

Any payment for accrued but untaken annual leave at the date of termination is treated as earnings and is fully subject to income tax and National Insurance contributions. This is not part of the £30,000 tax-free amount.

Payments Representing Salary or Benefits

Any element of a settlement payment that represents salary, bonus, commission, or other contractual benefits that the employee would have received regardless of the termination, for example, a payment covering the period up to the termination date, is fully taxable as earnings in the usual way.

Payments That May Qualify for the £30,000 Tax Exemption

The following types of payment, where genuinely compensatory and not representing earnings or contractual entitlements, may fall within the £30,000 tax-free threshold:

• Statutory redundancy pay — this counts towards the £30,000 limit but is itself exempt from income tax up to that threshold.
• Enhanced redundancy payments — including contractual redundancy payments, may qualify for the £30,000 income tax exemption where they fall within the statutory rules for termination payments and are not treated as earnings or post-employment notice pay.
• Ex gratia payments — genuine one-off compensatory payments that are not contractually required and are paid in recognition of the circumstances of the termination can qualify for the exemption up to £30,000.
• Compensation for loss of employment — payments made to compensate for the loss of the role itself, where they are not referable to notice or contractual entitlements, may fall within the exemption.

Where the total of these qualifying payments exceeds £30,000, the excess is subject to income tax at the employee’s marginal rate. Employer National Insurance contributions also apply to the excess.

Payments That May Be Paid Entirely Free of Tax

Compensation for Injury to Feelings and Personal Injury

Where a settlement agreement includes a payment specifically in respect of a personal injury, including a recognised psychiatric injury, that payment may be paid entirely free of income tax, outside the £30,000 threshold. This applies where the payment is genuinely and exclusively in respect of the injury itself. Injury to feelings awards are generally taxable where they relate to the termination of employment or arise from discrimination connected with employment. However, where a payment is genuinely made in respect of a recognised psychiatric or other personal injury, different tax treatment may apply under the statutory personal injury exemption. The distinction can be significant and should be considered carefully when structuring a settlement agreement.

Legal Fees Paid Directly to the Legal Adviser

Where the employer pays a contribution towards the employee’s legal fees for settlement agreement advice directly to the employee’s legal adviser rather than to the employee, that payment is exempt from income tax but is subject to VAT. It is standard practice for the employer to pay the legal fees contribution directly to the solicitor rather than through the employee’s payroll.

Outplacement Counselling

Where the employer provides or pays for genuine outplacement counselling services to assist the employee in finding new employment, the cost of those services is generally exempt from income tax provided certain conditions are met.

The Tax Indemnity Clause

Most settlement agreements include a tax indemnity clause, under which the employee indemnifies the employer against any additional tax liability that HMRC may assess if it takes a different view of the tax treatment of the settlement payment than the parties assumed when the agreement was signed. This clause is intended to allocate responsibility between the parties if HMRC later concludes that additional tax is payable. The precise effect depends on the wording of the indemnity and the circumstances of the case. It is important to understand the scope of any tax indemnity clause in your settlement agreement and to take tax advice where there is any uncertainty about the correct treatment of the payments being made.

Pension Scheme Contributions

In some settlement agreements, part of the payment is structured as a contribution to the employee’s pension scheme. Employer contributions to a registered pension scheme are generally not treated as taxable earnings for the employee, subject to the relevant tax legislation, including the annual allowance and any other applicable pension tax rules. Structuring part of a settlement payment as a pension contribution can therefore be a tax-efficient approach where the employee has remaining annual allowance available. This is an area where specialist tax advice is recommended alongside legal advice on the settlement agreement.

Understanding Your Settlement Agreement Tax Position

The tax treatment of settlement agreement payments is an area where getting the right advice before you sign can make a material difference to what you actually receive. At Duncan Lewis, our specialist settlement agreement solicitors advise employees on the terms of settlement agreements, including the tax implications of each element of the payment. We will ensure you understand which parts of your settlement are subject to tax and which may be paid free of tax, and we can recommend specialist tax advisers where the position is complex.

Learn more about settlement agreements here.