Settlement Agreement Tax Calculator

Key Points

How Settlement Agreement Tax Works

Settlement agreement tax is one of the most misunderstood areas of employment law. Most people assume the entire payment is tax-free up to £30,000, but that is not how it works. Your settlement package is made up of different types of payment, and each one is taxed differently.

Since April 2018, all payments in lieu of notice are taxable as earnings, regardless of what your contract says. Holiday pay, bonus, and commission payments are taxed normally too. Only the genuine compensation element qualifies for the £30,000 exemption, and statutory redundancy pay uses up part of that threshold before your ex-gratia payment is counted.

Payments that are tax-free (subject to the £30,000 threshold)

The first £30,000 of qualifying termination payments can be paid free of income tax and National Insurance under section 403 of the Income Tax (Earnings and Pensions) Act 2003. This covers genuine compensation for loss of employment (often called an ex-gratia payment) and statutory redundancy pay.

These qualifying payments are combined and measured against a single £30,000 threshold. If your statutory redundancy pay is £10,000 and your ex-gratia payment is £25,000, the combined total is £35,000. The first £30,000 is tax-free and the remaining £5,000 is taxable.

Employer contributions to your legal fees are also tax-free, provided they are paid directly to your solicitor under the terms of the settlement agreement. These do not count towards the £30,000 threshold at all (section 413A ITEPA 2003).

Payments taxed as earnings (income tax and National Insurance)

Some elements of your settlement are taxed in exactly the same way as your normal salary. These include payment in lieu of notice (PILON), accrued but untaken holiday pay, outstanding bonus or commission, and any salary arrears.

Since 6 April 2018, all notice pay is taxable regardless of whether your contract contains a PILON clause. This was a significant change introduced by the Finance (No.2) Act 2017. Before this date, non-contractual PILONs could sometimes fall within the £30,000 exemption. That is no longer the case.

“The single biggest mistake I see is people assuming their entire settlement payment is tax-free. It almost never is. The £30,000 exemption only applies to genuine compensation, and your notice pay, holiday pay, and bonus are always taxed as normal earnings. Getting this wrong can mean taking home thousands less than you expected.”

Tom Street Principal Solicitor, Tom Street & Co.

Post-Employment Notice Pay (PENP)

If you are not working your full notice period, your employer must calculate Post-Employment Notice Pay under section 402D of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). PENP represents the basic pay you would have earned during any unworked notice period, and it is taxed as earnings even if the settlement agreement does not separately identify it as notice pay.

The PENP formula uses your basic pay (excluding overtime, bonus, commission, allowances, and benefits in kind), the number of unworked notice days, and the length of your last pay period. For monthly-paid employees, a standardised divisor of 30.42 days is used. This became mandatory from 6 April 2021 under section 402D(6A) ITEPA 2003.

The formula itself is: PENP = ((BP x D) / P) – T, where BP is your basic pay in the last pay period, D is the number of calendar days of unworked notice, P is the number of days in the pay period (30.42 for monthly), and T is any notice pay already taxed as earnings. Our calculator provides an approximate PENP estimate based on your salary and notice details. Your employer’s payroll team will calculate the precise figure using exact dates.

You can find more detail in HMRC’s Employment Income Manual at EIM13880.

Compensation Above £30,000

If your total qualifying payments exceed £30,000, the excess is subject to income tax at your marginal rate. There is an important distinction here: you do not pay employee National Insurance on this excess. Employer Class 1A National Insurance applies above £30,000, but that is your employer’s liability, not yours. This means the tax treatment above £30,000 is more favourable than normal earnings.

Tax bands for 2025/26

If you earn more than £100,000, your personal allowance is reduced by £1 for every £2 above that threshold. It is completely withdrawn at £125,140. Our calculator accounts for this taper.

Scottish Taxpayers

If you are a Scottish taxpayer, different income tax rates and bands apply to the taxable elements of your settlement. Scotland has six income tax bands compared to three in England, Wales, and Northern Ireland, with rates ranging from 19% (starter rate) to 48% (top rate) for 2025/26. The calculator accounts for this when you select Scotland as your tax residence.

National Insurance rates are the same across the whole of the UK.

What the Calculator Does Not Cover

Settlement agreements can include complex elements that require individual professional advice. The calculator does not cover share options or employment-related securities, pension contributions from termination payments, injury to feelings awards in discrimination cases, payments structured across two tax years, salary sacrifice arrangements (which affect the PENP calculation), or payments for restrictive covenants.

If your settlement agreement includes any of these elements, speak to a solicitor. Your employer is required to pay for independent legal advice on your agreement.

Why Tax Treatment Matters

Most settlement agreements contain a tax indemnity clause. This means that if HMRC later decides a payment was taxed incorrectly, you could be required to reimburse your employer for any additional tax they have to pay. Getting the tax treatment right from the start protects you from unexpected liabilities down the line.

A solicitor reviewing your agreement will check that each payment is categorised correctly, that the PENP calculation is accurate, and that the tax indemnity clause is reasonable. This is one of the most important parts of the independent legal advice you receive, and it is one reason why having a specialist review your agreement matters.