Pensions and redundancy payments

Redundancy is never likely to be a pleasant experience but the pill is usually sweetened with a financial settlement. A redundancy payment is defined as “a severance payment made on genuine redundancy or loss of office”.

The first £30,000 is tax-free, with the balance taxed at the recipient&#39s marginal rate of income tax. Neither the employer nor the employee are liable for National Insurance contributions on redundancy payments. By using pensions, the efficiency of the excess over £30,000 can be significantly enhanced.

Looking first at personal pensions and stakeholder, the redundancy payment does not form part of net relevant earnings for contribution purposes. However, the payment, or part of it, may be used to fund the payment of a PP or ShP contribution up to the maximum for the appropriate tax year.

Examination of the past five years&#39 history may give useful leeway through selecting the best “basis year”. Carryback may also be used if appropriate. As the contribution would be paid net of basic-rate tax, with any higher rate being reclaimed separately, the effect of tax payment on any redundancy payment over £30,000 could be neutralised. Remember also that 25 per cent of the PP or ShP fund can be taken as tax-free cash.

Rather than being paid to the individual in full, an alternative would be for the employer to pay part or all of the excess over £30,000 into a PP or ShP, thus avoiding up to 40 per cent personal income tax.

The employer may, of course, claim corporation tax relief on this payment. Legal advice may have to be sought to check that the terms of the redundancy agreement allow this to happen.

Turning now to occupational pension schemes, the redundancy payment will not form part of pensionable earnings. However, the payment – or part of it – could be used to fund, for example, a free-standing additional voluntary contribution up to 15 per cent of total earnings from the employment in question.

Again, the contributions would be paid net of basic-rate tax, with higher-rate relief being claimed separately. No tax-free cash would be pay-able from the FSAVC policy. An alternative would be to contribute up to 15 per cent of earnings to an in-house AVC fund.

Again, tax-free cash would not be available directly from the AVC (unless the member joined it before April 8, 1987) but the trustees might have scope to augment the tax-free cash available.

In other words, they could decide that, as the AVC fund is available to augment pension benefits for the member, they are willing and able to provide a higher amount of tax free cash than would normally be the case.

Another option would be for the employee to give up all, or some, of the taxable part of the redundancy payment in order for the employer to make a contribution to an existing or new occupational pension scheme using this excess amount.

Again, the employer would have to make sure that the terms of any redundancy agreement would allow this to happen.

In the best case scenario, the employee could avoid paying 40 per cent tax on the excess over £30,000 and, depending on the circumstances, that is, service, salary or other arrangements, take the whole occupational pension fund tax-free at retirement.

The situation is different for the old S.226 retirement annuities. Here, the taxable portion of the redundancy payment does form part of the net relevant earnings and can be used both to justify a higher payment and to make a payment.

This assumes, of course, that the individual has a retirement annuity policy to which they can contribute.

Special situations may arise. For example, if the person being made redundant is over age 50, immediate vesting could be considered.

In an occupational pension scheme, this might require employers consent, failing which, a transfer to an individual contract could be considered.

Things may become a little simpler after the new Inland Revenue single regime comes in but today&#39s redundancy cases will not wait for that.