Are Settlement Agreements Taxable? [Employee Factsheet]

If your employer has offered you a settlement agreement, one of the questions you will likely ask is: “Are settlement agreements taxable?” The answer isn’t always straightforward.

This guide, designed for employees, walks you through everything you need to know about the tax implications of settlement agreements. We’ll cover the different types of payments included, how each is taxed (or not), and what HMRC rules say.

Let’s strip away the jargon and help you understand your rights and responsibilities.

What is a settlement agreement?

A settlement agreement is a legally binding contract between you and your employer. You are typically offered a financial payment in exchange for waiving your right to bring an employment claim (such as an unfair dismissal or constructive dismissal claim). Each settlement agreement is unique, but they often include the following financial elements:

• Salary payments
• Compensation (or ex gratia) payments
• Statutory redundancy pay
• Bonuses due
• Payment in lieu of notice
• Holiday pay duePension contributions.

Are settlement agreements tax-free?

In most cases, your employer can pay up to £30,000 of your settlement agreement tax-free – but not all payments qualify. The tax you need to pay depends on the type of payment received, and how it’s classified.

Tax-free settlement agreement payments

Some payments included in a settlement agreement can be made without deductions for tax or National Insurance. But HMRC sets strict rules on what qualifies. Below are the most common types of tax-free payments and the limits that apply.

Ex gratia payments

Ex gratia payments (or goodwill payments) are currently tax-free up to £30,000 (2025/26). Your employer pays these voluntarily, not as part of your contractual entitlements, and they are not made in return for work or services.

However, if your settlement agreement payment includes compensation above that threshold, the excess is subject to income tax.

Statutory or enhanced redundancy payments

If you’re made redundant, your termination payment may include both statutory redundancy pay (the minimum your employer must pay you based on your age, length of service, and weekly pay) and sometimes an enhanced redundancy payment, which is an additional amount offered by your employer. As long as the total settlement payment does not exceed £30,000, it is generally tax-free under HMRC rules.

Pension contributions

Your employer may agree to pay part of your settlement package into your pension rather than directly to you. This option can be tax-efficient, as pension contributions (within limits) are not subject to income tax or National Insurance. Under HMRC rules, most people can receive up to £60,000 (as of 2025/2026) in pension contributions per tax year without triggering a tax charge – this is known as the annual allowance. If, when making the payment into your pension as part of the settlement agreement, you stay within this allowance, it will typically be tax-free.

However, this strategy is not suitable for everyone. Always seek professional advice before deciding to direct settlement funds into your pension.

Legal fees

As part of the settlement agreement process, your employer will usually agree to pay a fixed amount for your legal advice. HMRC does not treat this as a taxable benefit because the payment is made directly to your solicitor (not to you). And for your agreement to be valid and enforceable, you must receive independent legal advice. In other words, it does not count as income, and you won’t be taxed on it.

What happens to “tax-free elements” above £30,000?

If your total settlement payment exceeds £30,000, HMRC will treat the portion above this limit as taxable income. Your employer will deduct the appropriate tax via PAYE before paying it to you.

However, even if individual payments for compensation and redundancy are each under £30,000, if the combined total exceeds this amount, the excess will be taxed. This is because the £30,000 tax-free limit applies to the total settlement amount, not each individual component separately.

Settlement agreement payments subject to tax

HMRC sees certain payments as earnings rather than compensation. That means they must be taxed like normal income. As such, your employer must deduct the correct income tax and National Insurance contributions before paying them to you, just like with your normal monthly wages.

Let’s break down the taxable payments in a typical settlement agreement a bit further:

Unpaid wages

Any basic salary owed to you up to your final working day is treated as standard income and will be subject to normal deductions for income tax and National Insurance. This includes your final month’s salary, any overtime worked but not yet paid, and any other earnings that were contractually due before your employment ended.

Bonus or commission payments

If you’re entitled to a bonus or commission, any outstanding payments will be treated as regular income and subject to tax and National Insurance deductions in the same way as your salary.

Holiday pay for unused leave

Any accrued but unused holiday must be paid out. So, if you’ve built up an unused holiday entitlement, it will be paid to you and taxed in the normal way.

PILON (Payment in Lieu of Notice)

A Payment in Lieu of Notice (PILON) is a payment made by your employer when they terminate your employment immediately without requiring you to work through your notice period. PILON is always treated as taxable income by HMRC (under the Post-Employment Notice Pay or PENP rules). This means it will be subject to the same income tax and National Insurance deductions as your regular salary or wages.

Payments for restrictive covenants

As part of a settlement agreement, your employer may ask you to agree to certain restrictions once your employment ends. These are known as restrictive covenants. If your employer pays you money in exchange for agreeing to these restrictions, this part of your settlement is not tax-free.

Tax benefits of a settlement agreement vs an employment tribunal award

A key advantage of settling a dispute through a settlement agreement rather than pursuing a claim through an employment tribunal is the potential tax efficiency of the payout.

• Settlement agreements: When structured correctly, a settlement agreement allows your employer to pay up to £30,000 of compensation tax-free.
• Employment tribunal awards: If you pursue your claim through a tribunal and win, any financial award is generally taxable in full.

For many employees, a settlement agreement offers a quicker, safer, and more tax-efficient route to compensation compared to going through a tribunal.

How much tax do I pay on a settlement agreement?

There’s no one-size-fits-all answer to this because it depends on how your settlement payment is set up. But in general, here’s what should happen:

• Your employer will figure out which parts of the payment are taxable and which aren’t
• They will summarise this in the settlement agreement contract. Your solicitor will check this for accuracy
• They’ll take the correct amount of tax and National Insurance off the taxable parts of the payment.

If you’re not sure about how your settlement is being taxed, it’s a good idea to check with your solicitor. They will ensure everything is done correctly.

What does HMRC say about settlement agreements?

HMRC has clear rules on how different parts of a settlement agreement should be taxed. Here are the key things to know:

• You can’t try to split or change the payment to avoid tax (for example, you can’t reclassify your PILON as something tax-free)
• The tax treatment should match the real purpose of the settlement agreement
• If your payment is more than £30,000, your employer has to report it to HMRC
• Your employer should ensure the right amount of tax is taken off before paying you.

How do I make sure the tax is correct?

Your solicitor should review the tax treatment of your settlement agreement. They will:

• Ask for a breakdown of how each part will be taxed
• Confirm whether everything is being taxed correctly
• Make sure any legal fees paid on your behalf are stated clearly.

Most settlement agreements include a tax indemnity clause, which means that if HMRC later decides more tax should have been paid, you – not your employer – will be responsible for paying it. That’s why getting advice on what tax might be due is essential – so there are no nasty surprises later.

Can I reduce the tax on my settlement agreement?

One way to potentially reduce the tax you pay on your settlement agreement is by directing part of your payment into your pension. Pension contributions are not subject to income tax or National Insurance, as long as they stay within your annual pension allowance.

However, any tax you legally owe must be paid. Always seek professional advice to make sure everything is done correctly.

FAQs on settlement agreement tax payments

Settlement agreement tax implications: Know where you stand

Settlement agreements can help you leave your employment on fair terms and receive compensation. But the tax treatment is key, and mistakes can be costly.

The golden rules?

• Don’t assume everything is tax-free
• Know the difference between taxable earnings and compensation
• Get clear legal advice to ensure the terms are right.

At GTE Settlement Agreement Solicitors, we specialise in fast, same-day settlement agreement advice.

Led by Gordon Turner, our specialise team have reviewed thousands of employee settlement agreements and are backed with over 550 Five Star reviews. For your free consultation, please call our friendly team today on 020 7247 7190 or complete the enquiry form on this page.