Is it worth putting redundancy money into your pension?

Workers made redundant with a pay-off of £30,000-plus can generate extra free cash by asking their employer to pay a chunk of the payout into their pension.

The move might be particularly beneficial for over-55s, who can gain immediate access to their pension pots if they want.

But doing this can drum up additional pension cash for people of any age, according to financial services provider LV=, which explains how below.

The coronavirus pandemic has caused a wave of job losses, and previous research has revealed many over-55s would seize the opportunity to take early retirement if they were made redundant, as they reassess their health and working life. 

If your employer pays part of your redundancy money into your pension, then just as with salary sacrifice you can get additional savings from National Insurance contributions, plus gain from tax relief top-ups, explains LV=.

Whether this is worth while depends on individual factors which we explore below, but for some the move will bring a welcome extra boost to retirement savings

How can putting redundancy money in a pension pay off?

The first £30,000 of a redundancy package is tax-free, while payments over this amount are subject to income tax and your employer pays National Insurance of 13.8 per cent, explains LV=.

So, you can take the £30,000 and then ask your employer to add any holiday pay, pay in lieu of notice and redundancy money over that amount into your pension.

It is worth asking your employer if they are prepared to add their NI savings to your pension contribution too, adds LV=.

‘This redundancy sacrifice works in the same way as salary sacrifice and allows the taxable element of a redundancy package to be exchanged for additional payments into a pension, resulting in savings for the employer and employee,’ it says.

‘Younger people can still benefit, but unless able to retire on ill-health grounds, won’t be able to access the pension until age 55.

‘Therefore, they need to be sure that they will not need the money in the short-term for anything else, for example tiding them over until they find a new job.’

As a redundancy payout up to £30,000 is tax free, it is usually not beneficial to put this in a pension. This portion of it does not attract tax relief, and when withdrawn from the pension, 75 per cent is subject to income tax.

You might decide you want to do this anyway, depending on your personal circumstances. But if so, LV= says seek financial advice first and ensure you only do so in a ‘relief at source’ pension scheme – meaning one where your provider claims income tax relief directly from HMRC, and adds it to your pension. 

‘Covid-19 is having a huge impact on the world’s economies and large numbers of people are facing redundancy,’ says David Stevens, director of savings at retirement at LV=.

‘Increasing numbers of people over 55 who are facing redundancy are considering taking early retirement,’

‘In these circumstances, it can make sense to pay part or all of their redundancy settlement into their pension.

‘Where possible, ask for the taxable element to be paid via redundancy sacrifice and see if the employer will pass on part or all of their ‘Class 1A’ NI saving.’

What are the pros and cons of putting redundancy cash into a pension?

Putting some redundancy money in a pension can be a useful tax planning tool as long as it suits your circumstances overall, says Sarah Coles, personal finance analyst at Hargreaves Lansdown.

It can be particularly valuable if the extra slice of redundancy pay will push you into a higher tax bracket, she explains.

You can have some of it paid into a pension instead, to cut the amount of higher rate tax you pay, and benefit from higher rate pension tax relief as well.

But Coles says that if you’re considering this move when you’re younger than 55, you need to ask whether this is the time to tie up a redundancy payment in a pension.

‘The level of uncertainty around at the moment means you may well need this money to fall back on while you’re looking for work, or to bridge the gap if you take a lower-paid job to keep you going through the crisis.’

If you are over 55 and plan to use redundancy to take early retirement, Coles highlights the following issues and potential pitfalls.

1. Pension recycling

Rules were brought in to stop people recycling the tax-free cash they get from one pension into another pension scheme, but they could affect people putting redundancy money in a pension too, says Coles.

‘If you make substantial increases in contributions around the time you take tax free cash from your pension, you need to be very careful that HMRC doesn’t consider it to be cash recycling.’ Read more here. 

2. Previous pension withdrawals

People who have tapped pots for any amount over and above their 25 per cent tax free lump sum are only able to put away £4,000 a year and still automatically qualify for tax relief from then onward. Read more here. 

3. Can you afford to retire?

‘If you’re bringing retirement forward, will this leave you with enough money to bridge the gap, and will you still be able to keep 1-3 years’ worth of essential expenses in easy access savings in case of emergencies?’ asks Coles.

Consider your overall financial plans – and if you have a big enough cash buffer

Anyone made redundant and due to receive a payment from their employer should think carefully about the best way to use the money, says Tom Selby, senior analyst at AJ Bell.

‘The starting point for most is likely to be building up a decent-sized ‘rainy day’ cash buffer if they don’t already have one.

‘A good target for this is enough to cover three to six months of fixed costs such as rent and bills. Paying off any high cost debts should then be prioritised to ensure you don’t rack up unnecessary interest bills.

‘Beyond this it’s worth considering saving and investing a redundancy payment, and one way to minimise the tax you pay is utilising salary sacrifice meaning your employer pays some of the taxable part of your redundancy payment into a pension.’

If you can get your employer to agree, this can give your retirement savings an extra boost.

But Selby notes that the total amount you can pay into a pension each year is limited at £40,000 for most people, while personal contributions cannot exceed 100 per cent of earnings. 

However, you are allowed to ‘carry forward’ unused allowance from the three previous tax years.