Settlement Agreement Tax Calculator

Expert Guide: Settlement Agreement Tax Rules 2026

A settlement agreement (formerly known as a compromise agreement) is a legally binding contract between an employer and employee, used to resolve a workplace dispute or to manage a departure on agreed terms. The tax treatment of settlement payments is one of the most complex and misunderstood areas of UK employment tax law.

The £30,000 Exemption — The Core Rule

Under ITEPA 2003 ss.401–404, the first £30,000 of a genuine, voluntary ex gratia payment is exempt from income tax. This exemption has been frozen at £30,000 since 1988. Key conditions for the exemption to apply:

• The payment must not be contractually obligated — it must be genuinely voluntary ("ex gratia")
• It must not be a payment for services (salary, bonus, commission)
• It must not be PILON (notice pay) or holiday pay
• The £30,000 limit applies across all payments from the same employer in the same employment
• Statutory redundancy pay counts toward the £30,000 limit

Amounts above £30,000 are taxed as employment income at your marginal rate. Since April 2018, employer and employee NICs also apply to the excess above £30,000. This was a significant change — previously, the excess was only subject to income tax.

Injury to Feelings and the Vento Bands

Compensation for injury to feelings arising from unlawful discrimination (protected characteristics under the Equality Act 2010) is generally tax-free and does not count toward the £30,000 limit. This is a separate exemption under ITEPA 2003 s.406. HMRC accepts injury to feelings payments as exempt where:

• The payment relates to a protected characteristic (age, disability, gender reassignment, marriage, pregnancy and maternity, race, religion or belief, sex, sexual orientation)
• The amount is consistent with Vento guidelines (updated annually by Presidential Guidance)
• The agreement clearly identifies the injury to feelings element

Legal Costs in Settlement Agreements

It is standard practice for employers to make a contribution to the employee's legal costs in negotiating and signing the settlement agreement. This contribution is tax-free under ITEPA 2003 s.413, provided:

• The payment is made directly to the employee's solicitor (not via the employee)
• The legal costs relate solely to advising on the settlement agreement itself
• The amount is reasonable (typical employer contributions range from £500 to £2,000)

If the legal cost contribution is paid to the employee, it will be treated as additional termination payment income and may be taxable if the £30,000 limit is already exhausted.

Negotiation Tactics: Maximising Your Net Receipt

Understanding the tax rules gives significant negotiating advantage. Professional advisers use the following strategies to maximise after-tax value:

• Maximise the ex gratia element — push for as much as possible to be framed as compensation within the £30,000 band, rather than as PILON or bonus.
• Use outplacement support — employer-provided career coaching and outplacement up to £30,000 is tax-free (ITEPA 2003 s.310) and can be offered as an alternative to cash, reducing employer NIC costs.
• Pension contributions — ask the employer to make a pension contribution rather than paying cash. Employer pension contributions are not subject to NICs and can often be made without breaching the annual allowance.
• Gross up the taxable elements — negotiate for the employer to gross up any taxable amounts above £30,000 so you receive your target net figure.
• Identify genuine injury to feelings — if discrimination is alleged, quantify an injury to feelings element separately and ensure it is clearly described as such in the agreement.
• Timing across tax years — if you are close to a tax year end, consider whether payment in the next tax year would result in a lower marginal rate (e.g. if you will not be working for part of the following year).

Worked Example: £75,000 Settlement

HMRC Clearance for Settlement Agreements

For high-value or complex settlements, HMRC offers non-statutory clearance under its clearance service. The employer (or their representative) can write to HMRC setting out the proposed payment structure and asking for confirmation of the tax treatment. HMRC aims to respond within 28 days. Clearance is not legally binding but provides a strong indication of HMRC's view. It is particularly valuable where: the injury to feelings element is large, the payment structure is unusual, or where there is genuine uncertainty about whether elements are contractual or voluntary. Your employment solicitor can draft the clearance application.

Sources & Methodology

Calculations use HMRC income tax and NIC rates for 2026/27. The £30,000 exemption applies under ITEPA 2003 ss.401–404. Injury to feelings figures use 2026 Presidential Guidance Vento bands for England and Wales.

• HMRC — Tax on Termination Payments
• ITEPA 2003 — Chapter 3: Payments on Termination
• HMRC Employment Income Manual — EIM12977