Redundancy payments being used for pension contributions
The current financial situation has increased the likelihood that some people will lose their jobs. Being made redundant can cause financial hardship but for others it can help them boost their pension savings.
- Only part of a redundancy payment counts as relevant UK earnings.
- A redundancy payment can be made up of the actual redundancy payment and other payments such as salary, holiday pay or payment in lieu of notice.
- Any part of a lump sum redundancy payment that comes from salary, payment in lieu of notice, or holiday pay does count as relevant UK earnings
- Only the part of the redundancy payment over the tax-exempt threshold of £30,000 count as relevant UK earnings.
Can a redundancy payment be used to boost my pension savings?
Potentially, yes, though only part of a redundancy payment counts as relevant UK earnings. Tax relief on individual contributions is restricted to the higher of £3,600 or 100% of relevant UK earnings.
Why can’t I pay the whole redundancy payment into my pension plan?
A redundancy payment can be made up of the actual redundancy payment and other payments such as:
- holiday pay
- payment in lieu of notice (PILON).
Any part of a lump sum redundancy payment that comes from salary, bonuses, PILON, or holiday pay does count as relevant UK earnings. However, only the part of the actual redundancy payment over the tax-exempt threshold of £30,000 will be classed as employment income and count as relevant UK earnings.
How do I calculate how much of the redundancy payment can be paid into a pension plan?
Let's look at an example where an individual receives a lump sum payment on redundancy that's made up as follows:
- one month’s salary - £2,500
- one month’s salary in lieu of notice - £2,500
- holiday pay - £750
- redundancy payment - £31,250
- total - £37,000
The first three items all count as relevant UK earnings. In addition to that, £1,250 of the redundancy payment is also classed as relevant UK earnings. So this redundancy payment will add £7,000 to the individual’s relevant UK earnings for the tax year.
Remember the relevant earnings will only be for the part of the year worked before redundancy, unless, they get a new job within that tax year.
Is there anything else to watch out for?
In the normal way, if total contributions (including any made from the redundancy payment) in a tax year are over the annual allowance (AA), the individual may be subject to an AA tax charge. They may be able to carry forward unused AA from previous tax years in order to avoid this charge. If the redundancy payment is large or the individual was a high earner you should check whether the tapering of annual allowance applies.
Similarly, if the money purchase annual allowance (MPAA) applies this will restrict how much can be paid into a money purchase plan. Remember carry forward is not available if the MPAA has been triggered.
Can you use salary exchange?
Alternatively, the individual can ask the employer to pay some or all the payment as an employer contribution. This doesn’t require a formal exchange of letters as it isn’t a salary or bonus exchange but has the same result.
What about tax relief?
Any tax relief on individual contributions is restricted to the higher of £3,600 or 100% of relevant UK earnings, as normal. Corporation tax will be paid on any employer contribution paid as a result of the redundancy subject to the wholly and exclusively for the purpose of the trade rules.
Taxable income can be reduced significantly by making personal contributions to a pension as the contribution will extend the basic rate band.
If the contributions can bring the adjusted net income down to below £100,000 and retain the personal allowance giving 60 tax relief on pension contributions, or 61.5% tax relief on pension contributions in Scotland.
What can be done with the first £30,000 of the redundancy payment?
As the first £30,000 is not relevant UK earnings it cannot be used to support a personal contribution.
However, it is important to remember that the individual may have relevant UK earnings from before they get their redundancy payment. For example, the individual earns £20,000 between April and August and then gets made redundant. The redundancy payment is £37,000 of which £7,000 is relevant UK earnings. So they have total relevant UK earnings of £27,000. So could pay £27,000 of the redundancy payment as a pension contribution.
In addition, if the individual gets another job before the end of the tax year, they will have more relevant UK earnings, those new earnings can be used to support more pension contribution paid from the redundancy payment.
If it isn’t possible to pay any more into the individual’s own pension it can be used to make a third-party contribution for someone else.
It could be used to pay £3,600 gross to a non-taxpayers pension plan, for example a child or grandchild. If the individual was married or in a civil partnership, depending on their relevant UK earnings some or all of the £30,000 could be paid into their pension plan. Similarly a payment could be made to an adult child’s pension on the same basis
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.