Settlement Agreement Tax 2026/27: How Each Element Is Actually Taxed
A settlement agreement often bundles several different payment types together — notice pay, redundancy compensation, unused holiday, sometimes a genuine ex-gratia sum — and each is taxed completely differently. Here's how to read the breakdown.
Why Settlement Agreement Tax Confuses People
A settlement agreement (formerly called a compromise agreement) is a legally binding document under which an employee agrees not to pursue certain claims against their employer — typically in exchange for a payment and agreed terms around the end of employment. Because settlement agreements are often negotiated as a single headline figure, it's easy to assume the whole amount qualifies for the well-known "£30,000 tax-free" treatment. It doesn't. HMRC requires each component of the payment to be assessed and taxed according to its actual substance, regardless of how the overall figure was negotiated or labelled.
The Typical Components of a Settlement Payment
| Component | What It Is | Tax Treatment |
|---|---|---|
| PILON (payment in lieu of notice) | Pay for the notice period you're not working | Fully taxed as earnings — PAYE + employee NI + employer NI |
| Unused/accrued holiday pay | Holiday you've earned but not taken | Fully taxed as earnings, no exemption |
| Contractual bonus/commission owed | Bonus you were already entitled to under your contract | Fully taxed as earnings, no exemption |
| Genuine ex-gratia/compensation payment | True compensation for loss of employment, not owed under contract | Tax-free up to £30,000; income tax only above that; employer (not employee) NI above £30,000 |
| Legal fees contribution | Paid towards your solicitor's advice fee | Generally not taxable if paid directly to the solicitor and required for the agreement's validity |
| Restrictive covenant payment | Payment in exchange for agreeing to post-termination restrictions (e.g. non-compete) | Fully taxed as earnings, regardless of amount |
Worked Example: A Typical Settlement Package
Suppose your settlement agreement totals £45,000, made up as follows:
| Component | Amount | Tax Treatment | Tax Due |
|---|---|---|---|
| PILON (2 months' notice) | £8,000 | Fully taxed as earnings | PAYE + employee/employer NI on full £8,000 |
| Unused holiday pay | £2,000 | Fully taxed as earnings | PAYE + employee/employer NI on full £2,000 |
| Genuine ex-gratia compensation | £35,000 | Tax-free up to £30,000; taxed above | Income tax only on £5,000 (the excess above £30,000); employer NI also due on this £5,000 |
| Total | £45,000 |
Note that the £35,000 "compensation" figure isn't simply £45,000 minus the other elements by coincidence — it should reflect the genuine, separately negotiated value of the compensation-for-loss-of-employment element, which your employer (often with legal/HR input) is responsible for calculating correctly and itemising in the settlement agreement and associated tax documentation.
Why the Labelling Must Reflect Substance, Not Just Wording
HMRC's Post-Employment Notice Pay (PENP) rules, introduced in April 2018, exist specifically to prevent employers and employees agreeing to relabel what is genuinely notice pay as "compensation" purely to access the £30,000 exemption. Even where a settlement agreement describes a payment as "ex-gratia" or "compensation," HMRC's PENP formula is applied to work out how much of the payment reflects unworked notice, and that portion must be taxed as PILON regardless of the label used in the agreement.
This means the actual tax outcome of a settlement agreement is determined by substance, not by how creatively it's worded — a properly drafted agreement, prepared with appropriate legal and payroll input, will correctly itemise and tax each element rather than attempting to disguise notice pay as tax-free compensation.
National Insurance: A Summary
| Element | Employee NI | Employer NI |
|---|---|---|
| PILON | Yes, in full | Yes, in full |
| Holiday pay / bonus | Yes, in full | Yes, in full |
| Compensation up to £30,000 | No | No |
| Compensation above £30,000 | No | Yes (since April 2020) |
The employer-only NI charge on compensation above £30,000 is a cost to the employer, not a deduction from what you receive — but it can factor into how generously an employer is willing to structure a settlement, since it represents a real additional cost to them on larger packages.
Practical Checklist Before Signing
- Ask for an itemised breakdown of the settlement figure — PILON, holiday pay, bonus, genuine compensation — before agreeing to a headline number.
- Confirm which elements the £30,000 exemption is being applied to and whether the employer's PENP calculation looks reasonable given your notice period and salary.
- Use your independent legal advice (a legal requirement for the agreement to be valid) to query the tax breakdown, not just the legal terms — many settlement agreement solicitors focus primarily on the legal releases and less on tax optimisation unless specifically asked.
- Understand your net (after-tax) figure, not just the gross headline number, when comparing an offer against your financial needs during the transition to new employment.
- Check the legal fees contribution is paid directly to your solicitor, which is the standard way to keep this element non-taxable.
Frequently asked questions
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