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01 Nov 20
Redundancy and Tax – A Case Study
During Covid and the resulting financial fallout, many companies have had to make the hard decision to make some of their staff redundant. Our Chartered Financial Planner Michael Hawthorne looks at how a redundancy payment affected one of his clients below and how he was able to help:
“I recently had a very unhappy client, contacting me to discuss what to do with their redundancy payment. The redundancy came at a good time so why was he unhappy?
With over 35 plus years with the same firm, my client was expecting a six-figure sum. He was aware that the first £30k was tax free. The rest of the redundancy is taxable and although income for the year would fall into the basic rate tax band (20%), when the redundancy payment was added to income, some would be taxed at 40% and some at the effective tax rate of 60%. This is because when income exceeds £100k, an individual loses their personal allowance* by 50p per £1. This would mean a total loss of personal allowance for income over £125,000 (including redundancy payments).
I am sure anybody who has had a sizeable redundancy payment was shocked at the amount of tax deducted prior to it landing in their bank account!
How does the tax work?
Here is an example to demonstrate:
|Earnings in the year of redundancy||£30,000|
|Total taxable income||£120,000|
|Tax on Redundancy Payment:|
|Taxed at 20% on first £20,000||£4,000|
|Taxed at 40% on £50,000||£20,000|
|60% tax on £20,000 through loss of £10,000 of personal allowance||£12,000|
|Total Tax||£36,000 (Ouch!)|
What can be done about it?
In the right circumstances, a pension contribution could reclaim much, maybe all of this tax.
The current system allows for tax relief at the rate of tax paid (we call this the marginal rate of tax) which means in the above example, a £20,000 contribution would receive the effective tax saving of £12,000 (60%), a further £50,000 might receive tax relief of £20,000 (40%) and so on.
There are strict rules regarding the amounts you can pay into a pension each year. These centre around earnings and an annual allowance but, in certain conditions, unused allowances from previous years can also be used.
Now, for my client, the stars were aligned and I was able to help to provide a solution that bettered their financial position and claw back an amount of tax not too dis-similar to the above example – no more unhappiness!”
* The personal allowance is the amount of income an individual can received tax free each tax year and currently stands at £12,500